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Monetary Policy In The Open Economy Revisited: Price Setting Rules And Exchange Rate Flexibility

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  • Devereux, Michael B
  • Engel, Charles M

Abstract

This paper develops a welfare-based model of monetary policy in an open economy. We focus on the extent to which monetary policy should be employed in maintaining the exchange rate. 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 in industrialized countries - the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of local-currency pricing, we find that optimal monetary policy in response to real shocks pricing is fully consistent with fixed exchange rates. On the other hand, when real country-specific shocks are not important, and when a country's monetary sector is stable, the case for freely floating rates (a monetary policy in which exchange rates are not a consideration) is strengthened in the presence of local-currency pricing.

Suggested Citation

  • Devereux, Michael B & Engel, Charles M, 2000. "Monetary Policy In The Open Economy Revisited: Price Setting Rules And Exchange Rate Flexibility," CEPR Discussion Papers 2454, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:2454
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    References listed on IDEAS

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    More about this item

    Keywords

    Expenditure Switching; Flexible Exchange Rates; Local Currency Pricing; Monetary Policy;
    All these keywords.

    JEL classification:

    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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