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

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  • Michael B. Devereux

    (University of British Columbia)

Abstract

A classic argument for flexible exchange rates is that the exchange rate plays a 'shock-absorber' role in an open economy vulnerable to country-specific shocks. This paper presents a sharp counter-example to this argument within a very conventional 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 internationally. A flexible exchange rate policy acts perfectly as a 'shock-absorber', fully stabilizing output and replicating the flexible wage outcome. Despite this, a policy that fixes the exchange rate may be welfare superior, even though fixed exchange rates cause output to deviate 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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Bibliographic Info

Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 122001.

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Length: 26 pages
Date of creation: Oct 2001
Date of revision:
Handle: RePEc:hkm:wpaper:122001

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Cited by:
  1. Devereux, Michael B., 2004. "Should the exchange rate be a shock absorber?," Journal of International Economics, Elsevier, vol. 62(2), pages 359-377, March.
  2. Alan Sutherland, 2002. "International monetary policy coordination and financial market integration," International Finance Discussion Papers 751, Board of Governors of the Federal Reserve System (U.S.).

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