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Openness and the case for flexible exchange rates

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  • Corsetti, Giancarlo

Abstract

Models of stabilization in open economy traditionally emphasize the role of exchange rates as a substitute for nominal price flexibility in fostering relative price adjustment. This view has been recently criticized on the ground that, to the extent that prices are sticky in local currency, the exchange rate does not play the stabilizing role envisioned by the received wisdom. An important question is whether, for this very reason, stabilization policies should limit exchange rate movements, or even eliminate them altogether. In this paper, I re-assess this issue by extending the Corsetti and Pesenti (2001) model to allow for home bias in consumption, so that I can exploit the advantages of closed-form solutions. While this extension leaves most properties of the model unaffected, home bias implies that the real exchange rate in an efficient equilibrium is not constant, but fluctuates with the terms of trade. The weight that monetary authorities optimally place on stabilizing domestic marginal costs is increasing in Home bias. With asymmetric shocks, fixed exchange rates are incompatible with efficient monetary rules. Yet, the adverse welfare consequences of exchange rate movements constrain the optimal intensity of monetary responses to domestic shocks. Openness matters: the larger the import content of consumption, the lower the exchange rate volatility implied by optimal stabilization rules.

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Bibliographic Info

Article provided by Elsevier in its journal Research in Economics.

Volume (Year): 60 (2006)
Issue (Month): 1 (March)
Pages: 1-21

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Handle: RePEc:eee:reecon:v:60:y:2006:i:1:p:1-21

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Web page: http://www.elsevier.com/locate/inca/622941

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  1. Michael B. Devereux & Charles Engel, 2005. "Expenditure Switching vs. Real Exchange Rate Stabilization: Competing Objectives for Exchange Rate Policy," Working Papers 082005, Hong Kong Institute for Monetary Research.
  2. Giancarlo Corsetti & Paolo Pesenti, 2002. "Self-Validating Optimum Currency Areas," NBER Working Papers 8783, National Bureau of Economic Research, Inc.
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