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Exchange Rate Policy and Endogenous Price Flexibility

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  • Michael B. Devereux

Abstract

Most theoretical analysis of flexible versus fixed exchange rates takes the degree of nominal rigidity to be independent of the exchange rate regime choice itself; however, informal policy discussion often suggests that a credible exchange rate peg may increase internal price flexibility. This paper explores the relationship between exchange rate policy and price flexibility, in a model where price flexibility itself is an endogenous choice of profit-maximizing firms. A fixed exchange rate can affect the optimal degree of price flexibility by altering the volatility of nominal demand facing price-setting firms. We find that a unilateral peg, such as a currency board, adopted by a single country, will increase internal price flexibility, perhaps by a large amount. On the other hand, when an exchange rate peg is supported by bilateral participation of all monetary authorities such as in a monetary union, price flexibility may actually be less than under freely floating exchange rates. Quantitatively, we find that the endogenous increase in price flexibility following a unilateral peg might be large enough that output volatility is no greater than it would be under a floating exchange rate regime. (JEL: F0, F4) Copyright (c) 2006 by the European Economic Association.

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Bibliographic Info

Article provided by MIT Press in its journal Journal of the European Economic Association.

Volume (Year): 4 (2006)
Issue (Month): 4 (06)
Pages: 735-769

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Handle: RePEc:tpr:jeurec:v:4:y:2006:i:4:p:735-769

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Cited by:
  1. Senay, Ozge & Sutherland, Alan, 2010. "Endogenous Price Flexibility and Optimal Monetary Policy," SIRE Discussion Papers 2010-16, Scottish Institute for Research in Economics (SIRE).
  2. Beladi, Hamid & Chakrabarti, Avik & Marjit, Sugata, 2010. "Exchange rate pass-through: A generalization," Journal of Mathematical Economics, Elsevier, vol. 46(4), pages 493-504, July.
  3. Pang, Ke, 2013. "Financial integration, nominal rigidity, and monetary policy," International Review of Economics & Finance, Elsevier, vol. 25(C), pages 75-90.

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