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

  • Devereux, Michael B
  • Engel, Charles M

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2454.

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Date of creation: May 2000
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Handle: RePEc:cpr:ceprdp:2454
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  1. 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.
  2. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 553-578, June.
  3. Engel, C., 1996. "Accounting for U.S. Real Exchange Rate Changes," Working Papers 96-02, University of Washington, Department of Economics.
  4. Maurice Obstfeld, 1999. "Open-Economy Macroeconomics, Developments in Theory and Policy," NBER Working Papers 6319, National Bureau of Economic Research, Inc.
  5. Svensson, Lars E O, 1998. "Open-Economy Inflation Targeting," CEPR Discussion Papers 1989, C.E.P.R. Discussion Papers.
  6. Engel, Charles & Rogers, John H, 1996. "How Wide Is the Border?," American Economic Review, American Economic Association, vol. 86(5), pages 1112-25, December.
  7. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare and Macroeconomic Interdependence," The Quarterly Journal of Economics, Oxford University Press, vol. 116(2), pages 421-445.
  8. Maurice Obstfeld & Kenneth Rogoff, 2000. "New Directions for Stochastic Open Economy Models," International Finance 0004002, EconWPA.
  9. 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.
  10. Maurice Obstfeld & Kenneth Rogoff, 1994. "Exchange Rate Dynamics Redux," NBER Working Papers 4693, National Bureau of Economic Research, Inc.
  11. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476.
  12. 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.
  13. Engel, Charles, 1993. "Real exchange rates and relative prices : An empirical investigation," Journal of Monetary Economics, Elsevier, vol. 32(1), pages 35-50, August.
  14. 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.
  15. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August.
  16. Yushi Yoshida & Shinji Takagi, 1999. "Exchange Rate Movements and Tradable Goods Prices in East Asia; An Analysis Based on Japanese Customs Data, 1988-98," IMF Working Papers 99/31, International Monetary Fund.
  17. 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.
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