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Exchange Rate Policy and Endogenous Price Flexibility

  • Devereux, Michael B

A fixed exchange rate limits the ability of the real exchange rate to adjust to shocks, and tends to raise the volatility of real GDP. But adjustment may be enhanced if internal prices are more flexible under a fixed exchange rate. This Paper develops a model in which price setters incur a cost to retain the option of ex-post price flexibility. The benefit of flexibility is increasing in the variance of demand facing price-setters. We ask whether fixing the exchange rate is likely to increase price flexibility. For a unilateral peg followed by one country alone, the answer is yes. Moreover, because there is a strategic complementarity in the choice of price flexibility, the increase in flexibility following an exchange rate peg can be very large. It is even possible that the increase in internal flexibility following an exchange rate peg is so great that it overturns the direct effect, and GDP is more stable after a peg. On the other hand, when an exchange rate peg is supported by bilateral participation of both monetary authorities (such as a monetary union), the degree of price flexibility may actually be less than under freely floating exchange rates. The model also allows for multiple, self-fulfilling equilibria in the degree of price flexibility.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4121.

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Date of creation: Nov 2003
Date of revision:
Handle: RePEc:cpr:ceprdp:4121
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  1. Obstfeld, Maurice & Rogoff, Kenneth, 2001. "Global Implications of Self-Orientated National Monetary Rules," CEPR Discussion Papers 2856, C.E.P.R. Discussion Papers.
  2. Jeffrey A. Frankel & Andrew K. Rose, 1996. "The Endogeneity of the Optimum Currency Area Criteria," NBER Working Papers 5700, National Bureau of Economic Research, Inc.
  3. 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.
  4. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," NBER Working Papers 7665, National Bureau of Economic Research, Inc.
  5. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "New directions for stochastic open economy models," Journal of International Economics, Elsevier, vol. 50(1), pages 117-153, February.
  6. Philippe BACCHETTA & Eric VAN WINCOOP, 1999. "Does Exchange Rate Stability Increase Trade and Welfare ?," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 9917, Université de Lausanne, Faculté des HEC, DEEP.
  7. Lane, P, 1999. "The New Open Economy Macroeconomics: A Survey," Trinity Economics Papers 993, Trinity College Dublin, Department of Economics.
  8. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2000. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," NBER Working Papers 7869, National Bureau of Economic Research, Inc.
  9. Kollmann, Robert, 2001. "The exchange rate in a dynamic-optimizing business cycle model with nominal rigidities: a quantitative investigation," Journal of International Economics, Elsevier, vol. 55(2), pages 243-262, December.
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  11. Helpman, Elhanan, 1981. "An Exploration in the Theory of Exchange-Rate Regimes," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 865-90, October.
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  16. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 743-764, October.
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  18. Obstfeld, M., 1998. "Risk and Exchange Rate," Papers 193, Princeton, Woodrow Wilson School - Public and International Affairs.
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  20. Devereux, Michael B., 2004. "Should the exchange rate be a shock absorber?," Journal of International Economics, Elsevier, vol. 62(2), pages 359-377, March.
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