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International Risk-Sharing and the Exchange Rate: Re-evaluating the Case for Flexible Exchange Rates

  • Devereux, Michael B

A classic argument for flexible exchange rates is that the exchange rate plays a ‘shock-absorber' role in an open economy hit by country specific shocks. This Paper presents a sharp counterexample to this argument within a very simple open economy model. Countries are subject to unpredictable shocks to world demand for their goods. Efficient adjustment is prevented, both by sticky nominal wages and by the absence of a market for hedging consumption risk across countries. A flexible exchange rate policy, by stabilizing domestic prices, fully stabilizes output and replicates the flexible wage outcome, acting perfectly as a ‘shock absorber’. Despite this, a policy that fixes the exchange rate may be welfare superior, even though fixed exchange rates cause GDP to fluctuate away from the flexible wage outcome. Moreover, an optimal monetary rule in this environment would always dampen exchange rate movements, and may even be a fixed exchange rate.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2900.

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Date of creation: Jul 2001
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Handle: RePEc:cpr:ceprdp:2900
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  1. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1991. "International real business cycles," Staff Report 146, Federal Reserve Bank of Minneapolis.
  2. Michael Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibiity," Discussion Papers in Economics at the University of Washington 0016, Department of Economics at the University of Washington.
  3. Murray, John, 1999. "Why Canada Needs a Flexible Exchange Rate," Working Papers 99-12, Bank of Canada.
  4. Paul Krugman, 1999. "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Springer, vol. 6(4), pages 459-472, November.
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  10. Fukuda, Shin-ichi & Hoshi, Takeo & Ito, Takatoshi & Rose, Andrew, 2006. "International Finance," Journal of the Japanese and International Economies, Elsevier, vol. 20(4), pages 455-458, December.
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  12. Maurice Obstfeld and Kenneth Rogoff., 1995. "Exchange Rate Dynamics Redux," Center for International and Development Economics Research (CIDER) Working Papers C95-048, University of California at Berkeley.
  13. Lane, Philip R., 2001. "The new open economy macroeconomics: a survey," Journal of International Economics, Elsevier, vol. 54(2), pages 235-266, August.
  14. Eric van Wincoop & Philippe Bacchetta, 2000. "Does Exchange-Rate Stability Increase Trade and Welfare?," American Economic Review, American Economic Association, vol. 90(5), pages 1093-1109, December.
  15. Eric Parrado & Andres Velasco, 2002. "Optimal Interest Rate Policy in a Small Open Economy," NBER Working Papers 8721, National Bureau of Economic Research, Inc.
  16. Charles Engel, 1995. "Accounting for U.S. Real Exchange Rate Changes," NBER Working Papers 5394, National Bureau of Economic Research, Inc.
  17. Alberto Alesina & Robert J. Barro, 2001. "Dollarization," American Economic Review, American Economic Association, vol. 91(2), pages 381-385, May.
  18. Tommaso Monacelli, 2000. "Relinquishing Monetary Policy Independence," Boston College Working Papers in Economics 483, Boston College Department of Economics.
  19. 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.
  20. 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.
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