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Expenditure Switching vs. Real Exchange Rate Stabilization: Competing Objectives for Exchange Rate Policy

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  • Michael B. Devereux

    (University of British Columbia and CEPR, Hong Kong Institute for Monetary Research)

  • Charles Engel

    (University of Wisconsin and NBER)

Abstract

This paper develops a view of exchange rate policy as a trade-off between the desire to smooth fluctuations in real exchange rates so as to reduce distortions in consumption allocations, and the need to allow flexibility in the nominal exchange rate so as to facilitate terms of trade adjustment. We show that optimal nominal exchange rate volatility will reflect these competing objectives. The key determinants of how much the exchange rate should respond to shocks will depend on the extent and source of price stickiness, as well as the elasticity of substitution between home and foreign goods. Quantitatively, we find the optimal exchange rate volatility should be significantly less than would be inferred based solely on terms of trade considerations. Moreover, we find that the relationship between price stickiness and optimal exchange rate volatility may be non-monotonic.

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Bibliographic Info

Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 082005.

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Length: 31 pages
Date of creation: Aug 2005
Date of revision:
Handle: RePEc:hkm:wpaper:082005

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References

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  1. Charles Engel & John H. Rogers, 1994. "How Wide is the Border?," NBER Working Papers 4829, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Devereux, Michael B & Shi, Kang & Xu, Juanyi, 2004. "Global Monetary Policy Under a Dollar Standard," CEPR Discussion Papers 4317, C.E.P.R. Discussion Papers.
  2. Wei Liao & Kang Shi & Zhiwei Zhang, 2010. "Vertical Trade and China's Export Dynamics," Working Papers 102010, Hong Kong Institute for Monetary Research.
  3. Giancarlo Corsetti & Luca Dedola & Sylvain Leduc, 2007. "Optimal Monetary Policy and the Sources of Local-Currency Price Stability," NBER Chapters, in: International Dimensions of Monetary Policy, pages 319-367 National Bureau of Economic Research, Inc.
  4. Olivier Blanchard, 2007. "Current Account Deficits in Rich Countries," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 54(2), pages 127-158, June.
  5. Giancarlo Corsetti, 2005. "Openness and the case for flexible exchange rates," Economics Working Papers ECO2005/21, European University Institute.
  6. Enrique Martinez-Garcia, 2007. "A monetary model of the exchange rate with informational frictions," Globalization and Monetary Policy Institute Working Paper 02, Federal Reserve Bank of Dallas.
  7. Darracq Pariès, Matthieu, 2007. "International frictions and optimal monetary policy cooperation: analytical solutions," Working Paper Series 0834, European Central Bank.
  8. 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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