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Input Substitution, Export Pricing, and Exchange Rate Policy

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  • Kang Shi

    (The Chinese University of Hong Kong, Hong Kong Institute for Monetary Research)

  • Juanyi Xu

    (Hong Kong University of Science and Technology, Simon Fraser University, Hong Kong Institute for Monetary Research)

Abstract

This paper develops a small open economy model with sticky prices to show why a flexible exchange rate policy is not desirable in East Asian emerging market economies. We argue that weak input substitution between local labor and import intermediates in traded goods production and extensive use of foreign currency in export pricing in these economies can help to explain this puzzle. In the presence of these two trade features, the adjustment role of the exchange rate is inhibited, so even a flexible exchange rate cannot stabilize the real economy in face of external shocks. Instead, due to the high exchange rate pass-through, exchange rate changes will lead to instability in both inflation and production cost. As a result, a fixed exchange rate may dominate a monetary policy rule with high exchange rate flexibility in terms of welfare. In a sense, our finding provides a rationale for the "fear of floating" phenomenon in these economies. That is, "fear of floating" may be central banks' rational reaction when these economies are constrained by the trade features mentioned above.

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Bibliographic Info

Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 102008.

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Length: 28 pages
Date of creation: Oct 2008
Date of revision:
Handle: RePEc:hkm:wpaper:102008

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Keywords: Input Substitution; Export Pricing; Exchange Rate Flexibility; Welfare;

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References

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  1. Michael B. Devereux & James Yetman, 2002. "Price Setting and Exhange Rate Pass-Through," Working Papers 222002, Hong Kong Institute for Monetary Research.
  2. Michael B. Devereux & Philip Lane, 2001. "Exchange Rates and Monetary Policy in Emerging Market Economies," Trinity Economics Papers 200111, Trinity College Dublin, Department of Economics.
  3. Arminio Fraga & Ilan Goldfajn & André Minella, 2003. "Inflation Targeting in Emerging Market Economies," Working Papers Series 76, Central Bank of Brazil, Research Department.
  4. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," Departmental Working Papers 200106, Rutgers University, Department of Economics.
  5. Choudhri, Ehsan U. & Hakura, Dalia S., 2006. "Exchange rate pass-through to domestic prices: Does the inflationary environment matter?," Journal of International Money and Finance, Elsevier, vol. 25(4), pages 614-639, June.
  6. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Closing Small Open Economy Models," Departmental Working Papers 200115, Rutgers University, Department of Economics.
  7. Mark Gertler & Simon Gilchrist & Fabio M. Natalucci, 2007. "External Constraints on Monetary Policy and the Financial Accelerator," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(2-3), pages 295-330, 03.
  8. Cook, David & Devereux, Michael B, 2004. "External Currency Pricing and the East Asian Crisis," CEPR Discussion Papers 4642, C.E.P.R. Discussion Papers.
  9. Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "Stabilization Policy and the Costs of Dollarization," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 482-509, May.
  10. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
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  13. Devereux, Michael B. & Yetman, James, 2010. "Price adjustment and exchange rate pass-through," Journal of International Money and Finance, Elsevier, vol. 29(1), pages 181-200, February.
  14. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May.
  15. Rotemberg, Julio J, 1982. "Monopolistic Price Adjustment and Aggregate Output," Review of Economic Studies, Wiley Blackwell, vol. 49(4), pages 517-31, October.
  16. Basu, Susanto & Fernald, John G, 1997. "Returns to Scale in U.S. Production: Estimates and Implications," Journal of Political Economy, University of Chicago Press, vol. 105(2), pages 249-83, April.
  17. Eva Ortega & Nooman Rebei, 2006. "The Welfare Implications of Inflation versus Price-Level Targeting in a Two-Sector, Small Open Economy," Working Papers 06-12, Bank of Canada.
  18. Chang, Roberto & Velasco, Andres, 2006. "Currency mismatches and monetary policy: A tale of two equilibria," Journal of International Economics, Elsevier, vol. 69(1), pages 150-175, June.
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Cited by:
  1. Liao, Wei & Shi, Kang & Zhang, Zhiwei, 2012. "Vertical trade and China's export dynamics," China Economic Review, Elsevier, vol. 23(4), pages 763-775.

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