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Exchange Rate Policy and Endogenous Price Flexibility

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  • Devereux, Michael B

Abstract

A fixed exchange rate limits the ability of the real exchange rate to adjust to shocks, and tends to raise the volatility of real GDP. But adjustment may be enhanced if internal prices are more flexible under a fixed exchange rate. This Paper develops a model in which price setters incur a cost to retain the option of ex-post price flexibility. The benefit of flexibility is increasing in the variance of demand facing price-setters. We ask whether fixing the exchange rate is likely to increase price flexibility. For a unilateral peg followed by one country alone, the answer is yes. Moreover, because there is a strategic complementarity in the choice of price flexibility, the increase in flexibility following an exchange rate peg can be very large. It is even possible that the increase in internal flexibility following an exchange rate peg is so great that it overturns the direct effect, and GDP is more stable after a peg. On the other hand, when an exchange rate peg is supported by bilateral participation of both monetary authorities (such as a monetary union), the degree of price flexibility may actually be less than under freely floating exchange rates. The model also allows for multiple, self-fulfilling equilibria in the degree of price flexibility.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4121.

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Date of creation: Nov 2003
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Handle: RePEc:cpr:ceprdp:4121

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Keywords: exchange rate; sticky prices;

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  1. 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.
  2. V. V Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Oxford University Press, vol. 69(3), pages 533-563.
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  13. Helpman, Elhanan, 1981. "An Exploration in the Theory of Exchange-Rate Regimes," Scholarly Articles 3445091, Harvard University Department of Economics.
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  17. Devereux, Michael B., 2004. "Should the exchange rate be a shock absorber?," Journal of International Economics, Elsevier, vol. 62(2), pages 359-377, March.
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Cited by:
  1. 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.
  2. Pang, Ke, 2013. "Financial integration, nominal rigidity, and monetary policy," International Review of Economics & Finance, Elsevier, vol. 25(C), pages 75-90.
  3. Ozge Senay & Alan Sutherland, 2010. "Endogenous Price Flexibility and Optimal Monetary Policy," CDMA Working Paper Series 201007, Centre for Dynamic Macroeconomic Analysis.

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