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Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility

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  • Michael B. Devereux

    (University of British Columbia, CEPR)

  • Charles Engel

    (University of Washington and NBER)

Abstract

This paper develops a welfare-based model of monetary policy in an open economy. We focus on the extent to which monetary policy should be employed in stabilising the exchange rate. The traditional approach maintains that exchange rate flexibility is desirable in the presence of real country-specific shocks that require adjustment in relative prices. However, in light of empirical evidence on nominal price response to exchange-rate changes - specifically, that there appears to be a large degree of local-currency pricing in industrialized countries - the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of local-currency pricing, we find that optimal monetary policy in response to real shocks is fully consistent with fixed exchange rates. On the other hand, when real country-specific shocks are not important, and when a country's monetary sector is stable, the case for freely floating rates is strengthened in the presence of localcurrency pricing.

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Bibliographic Info

Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 042000.

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Length: 33 pages
Date of creation: Jul 2000
Date of revision:
Handle: RePEc:hkm:wpaper:042000

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  1. Bennett T. McCallum & Edward Nelson, 2000. "Nominal Income Targeting in an Open-Economy Optimizing Model," NBER Working Papers 6675, National Bureau of Economic Research, Inc.
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  3. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1997. "Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Business Cycles," NBER Working Papers 5876, National Bureau of Economic Research, Inc.
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  7. Michael B. Devereux & Charles Engel & C√ądric Tille, 2003. "Exchange Rate Pass-Through and the Welfare Effects of the Euro," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(1), pages 223-242, February.
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  9. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
  10. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare And Macroeconomic Interdependence," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 116(2), pages 421-445, May.
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  12. Atish R. Ghosh & Anne-Marie Gulde & Jonathan D. Ostry & Holger C. Wolf, 1997. "Does The Nominal Exchange Rate Regime Matter?," Working Papers, New York University, Leonard N. Stern School of Business, Department of Economics 97-09, New York University, Leonard N. Stern School of Business, Department of Economics.
  13. Obstfeld, M., 1998. "Risk and Exchange Rate," Papers, Princeton, Woodrow Wilson School - Public and International Affairs 193, Princeton, Woodrow Wilson School - Public and International Affairs.
  14. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 25(1), pages 117-214, January.
  15. Cedric Tille, 2000. ""Beggar-thy-neighbor" or "beggar-thyself"? the income effect of exchange rate fluctuations," Staff Reports, Federal Reserve Bank of New York 112, Federal Reserve Bank of New York.
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  17. Harold L. Cole & Maurice Obstfeld, 1989. "Commodity Trade and International Risk Sharing: How Much Do Financial Markets Matter?," NBER Working Papers 3027, National Bureau of Economic Research, Inc.
  18. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, Elsevier, vol. 50(1), pages 155-183, February.
  19. Michael B. Devereux & Charles Engel, 1998. "Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime," NBER Working Papers 6867, National Bureau of Economic Research, Inc.
  20. Charles Engel, 1992. "Real Exchange Rates and Relative Prices: An Empirical Investigation," NBER Working Papers 4231, National Bureau of Economic Research, Inc.
  21. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, Elsevier, vol. 50(1), pages 215-244, February.
  22. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics, Boston College Department of Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
  23. Jeffrey A. Frankel, 1999. "No Single Currency Regime is Right for All Countries or At All Times," NBER Working Papers 7338, National Bureau of Economic Research, Inc.
  24. Yushi Yoshida & Shinji Takagi, 1999. "Exchange Rate Movements and Tradable Goods Prices in East Asia," IMF Working Papers 99/31, International Monetary Fund.
  25. Betts, Caroline & Devereux, Michael B., 1996. "The exchange rate in a model of pricing-to-market," European Economic Review, Elsevier, Elsevier, vol. 40(3-5), pages 1007-1021, April.
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