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Exchange Rate Policy and Endogenous Price Flexibility

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  • Michael B. Devereux

    (The University of British Columbia)

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    Abstract

    Most theoretical analysis of flexible vs. fixed exchange rates take the degree of nominal rigidity to be independent of the exchange rate regime choice itself. But informal policy discussion often suggests that a credible exchange rate peg may increase internal price flexibility. This paper explores the relationship between exchange rate policy and price flexibility, in a model where price flexibility is an endogenous choice of profit-maximizing firms. A fixed exchange rate may increase the optimal degree of price flexibility by increasing the volatility of demand facing firms. We find that a unilateral peg, such as a Currency Board, adopted by a single country, will increase internal price flexibility, perhaps by a large amount. On the other hand, when an exchange rate peg is supported by bilateral participation of all monetary authorities (such as a monetary union), price flexibility is likely to be little affected, and may actually be less than under freely floating exchange rates.

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    Bibliographic Info

    Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 202004.

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    Length: 33 pages
    Date of creation: Oct 2004
    Date of revision:
    Handle: RePEc:hkm:wpaper:202004

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    Related research

    Keywords: Monetary Policy; Collateral Constraints; Exchange Rate;

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    References

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    1. Obstfeld, Maurice & Rogoff, Kenneth, 1999. "New Directions for Stochastic Open Economy Models," Center for International and Development Economics Research, Working Paper Series qt5pf7g8sh, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
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    3. 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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    8. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," Working Papers 042000, Hong Kong Institute for Monetary Research.
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    Cited by:
    1. Berger, Wolfram, 2006. "The choice between fixed and flexible exchange rates: Which is best for a small open economy?," Journal of Policy Modeling, Elsevier, vol. 28(4), pages 371-385, May.

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