Exchange Rate Policy and Endogenous Price Flexibility

Most theoretical analysis of flexible versus fixed exchange rates takes the degree of nominal rigidity to be independent of the exchange rate regime choice itself; however, 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 itself is an endogenous choice of profit-maximizing firms. A fixed exchange rate can affect the optimal degree of price flexibility by altering the volatility of nominal demand facing price-setting 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 in a monetary union, price flexibility may actually be less than under freely floating exchange rates. Quantitatively, we find that the endogenous increase in price flexibility following a unilateral peg might be large enough that output volatility is no greater than it would be under a floating exchange rate regime. (JEL: F0, F4) Copyright (c) 2006 by the European Economic Association.