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Exchange Rate Policy and Endogenous Price Flexibility

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  • Michael B. Devereux

Abstract

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.

Suggested Citation

  • Michael B. Devereux, 2006. "Exchange Rate Policy and Endogenous Price Flexibility," Journal of the European Economic Association, MIT Press, vol. 4(4), pages 735-769, June.
  • Handle: RePEc:tpr:jeurec:v:4:y:2006:i:4:p:735-769
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    Cited by:

    1. Pang, Ke, 2013. "Financial integration, nominal rigidity, and monetary policy," International Review of Economics & Finance, Elsevier, vol. 25(C), pages 75-90.
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    3. Beladi, Hamid & Chakrabarti, Avik & Marjit, Sugata, 2010. "Exchange rate pass-through: A generalization," Journal of Mathematical Economics, Elsevier, vol. 46(4), pages 493-504, July.
    4. Wolfram Berger, 2008. "Monetary Policy Rules for a Small Open Economy," Economic Notes, Banca Monte dei Paschi di Siena SpA, vol. 37(1), pages 1-30, February.

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    More about this item

    JEL classification:

    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General

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