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

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  • Michael Devereux
  • Charles Engel

Abstract

This paper develops a welfare-based model of monetary policy in an open economy. We examine the optimal monetary policy under commitment, focusing on the nature of price adjustment in determining policy. We investigate the implications of these policies for exchange-rate flexibility. 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 the 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 (LCP) in industrialized countries-the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of LCP, we find that the optimal monetary policy leads to a fixed exchange rate, even in the presence of country-specific shocks. This is true whether monetary policy is chosen cooperatively or non-cooperatively among countries. Copyright The Review of Economic Studies Limited, 2003.

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Bibliographic Info

Paper provided by University of Washington, Department of Economics in its series Working Papers with number 0016.

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Date of creation: Apr 2000
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Handle: RePEc:udb:wpaper:0016

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  1. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, Elsevier, vol. 43(3), pages 553-578, June.
  2. Svensson, Lars E O, 1998. "Open-Economy Inflation Targeting," CEPR Discussion Papers 1989, C.E.P.R. Discussion Papers.
  3. 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.
  4. 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.
  5. Maurice Obstfeld & Kenneth Rogoff, 2000. "New Directions for Stochastic Open Economy Models," International Finance, EconWPA 0004002, EconWPA.
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  7. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 100(4), pages 745-75, August.
  8. 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.
  9. Betts, Caroline & Devereux, Michael B., 1996. "The exchange rate in a model of pricing-to-market," European Economic Review, Elsevier, vol. 40(3-5), pages 1007-1021, April.
  10. 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.
  11. 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.
  12. 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.
  13. Engel, Charles & Rogers, John H, 1996. "How Wide Is the Border?," American Economic Review, American Economic Association, vol. 86(5), pages 1112-25, December.
  14. Cedric Tille, 2000. ""Beggar-thy-neighbor" or "beggar-thyself"? the income effect of exchange rate fluctuations," Staff Reports 112, Federal Reserve Bank of New York.
  15. Philippe Bacchetta & Eric van Wincoop, 1998. "Does exchange rate stability increase trade and capital flows?," Research Paper 9818, Federal Reserve Bank of New York.
  16. Engel, Charles, 1993. "Real exchange rates and relative prices : An empirical investigation," Journal of Monetary Economics, Elsevier, Elsevier, vol. 32(1), pages 35-50, August.
  17. Obstfeld, Maurice, 1998. " Open-Economy Macroeconomics: Developments in Theory and Policy," Scandinavian Journal of Economics, Wiley Blackwell, vol. 100(1), pages 247-75, March.
  18. Charles Engel, 1999. "Accounting for U.S. Real Exchange Rate Changes," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 107(3), pages 507-538, June.
  19. 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, vol. 44(1), pages 223-242, February.
  20. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
  21. 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.
  22. 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.
  23. Yushi Yoshida & Shinji Takagi, 1999. "Exchange Rate Movements and Tradable Goods Prices in East Asia," IMF Working Papers 99/31, International Monetary Fund.
  24. Maurice Obstfeld, 1997. "Europe's gamble," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 28(2), pages 241-317.
  25. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
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