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International Risk-Sharing and the Exchange Rate: Re-evaluating the Case for Flexible Exchange Rates

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Devereux, Michael B

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Abstract

A classic argument for flexible exchange rates is that the exchange rate plays a ‘shock-absorber' role in an open economy hit by country specific shocks. This Paper presents a sharp counterexample to this argument within a very simple open economy model. Countries are subject to unpredictable shocks to world demand for their goods. Efficient adjustment is prevented, both by sticky nominal wages and by the absence of a market for hedging consumption risk across countries. A flexible exchange rate policy, by stabilizing domestic prices, fully stabilizes output and replicates the flexible wage outcome, acting perfectly as a ‘shock absorber’. Despite this, a policy that fixes the exchange rate may be welfare superior, even though fixed exchange rates cause GDP to fluctuate away from the flexible wage outcome. Moreover, an optimal monetary rule in this environment would always dampen exchange rate movements, and may even be a fixed exchange rate.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2900.

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Date of creation: Jul 2001
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Handle: RePEc:cpr:ceprdp:2900

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Related research
Keywords: fixed exchange rates; flexible exchange rates; risk sharing;

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Find related papers by JEL classification:
E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
F31 - International Economics - - International Finance - - - Foreign Exchange
F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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  1. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare And Macroeconomic Interdependence," The Quarterly Journal of Economics, MIT Press, vol. 116(2), pages 421-445, May. [Downloadable!] (restricted)
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  2. Lane, Philip R., 2001. "The new open economy macroeconomics: a survey," Journal of International Economics, Elsevier, vol. 54(2), pages 235-266, August. [Downloadable!] (restricted)
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  3. Eric Parrado & Andres Velasco, 2002. "Optimal Interest Rate Policy in a Small Open Economy," NBER Working Papers 8721, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  4. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-60, June. [Downloadable!] (restricted)
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  5. Charles Engel, 1999. "Accounting for U.S. Real Exchange Rate Changes," Journal of Political Economy, University of Chicago Press, vol. 107(3), pages 507-538, June. [Downloadable!] (restricted)
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  6. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August. [Downloadable!] (restricted)
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  7. Murray, John, 1999. "Why Canada Needs a Flexible Exchange Rate," Working Papers 99-12, Bank of Canada. [Downloadable!]
  8. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 745-75, August. [Downloadable!] (restricted)
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  9. Cedric Tille, 2000. ""Beggar-thy-neighbor" or "beggar-thyself"? the income effect of exchange rate fluctuations," Staff Reports 112, Federal Reserve Bank of New York. [Downloadable!]
  10. Michael Woodford, 2001. "Inflation Stabilization and Welfare," NBER Working Papers 8071, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  11. Bayoumi, Tamim & Eichengreen, Barry, 1998. "Exchange rate volatility and intervention: implications of the theory of optimum currency areas," Journal of International Economics, Elsevier, vol. 45(2), pages 191-209, August. [Downloadable!] (restricted)
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  12. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November. [Downloadable!] (restricted)
  13. Alberto Alesina & Robert J. Barro, 2001. "Dollarization," American Economic Review, American Economic Association, vol. 91(2), pages 381-385, May. [Downloadable!] (restricted)
  14. Fukuda, Shin-ichi & Hoshi, Takeo & Ito, Takatoshi & Rose, Andrew, 2006. "International Finance," Journal of the Japanese and International Economies, Elsevier, vol. 20(4), pages 455-458, December. [Downloadable!] (restricted)
  15. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," NBER Working Papers 7665, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  16. Tommaso Monacelli, 2000. "Relinquishing Monetary Policy Independence," Boston College Working Papers in Economics 483, Boston College Department of Economics. [Downloadable!]
  17. Maurice Obstfeld, 2001. "International Macroeconomics: Beyond the Mundell-Fleming Model," NBER Working Papers 8369, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Sutherland, Alan, 2004. "International Monetary Policy Coordination and Financial Market Integration," CEPR Discussion Papers 4251, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  2. David Bowman & Brian M. Doyle, 2003. "New Keynesian, open-economy models and their implications for monetary policy," International Finance Discussion Papers 762, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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