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Openness and the case for flexible exchange rates

  • Giancarlo Corsetti

Models of stabilization in open economy traditionally emphasize the role of exchange rates as a substitute for nominal price flexibility in fostering relative price adjustment. This view has been recently criticized on the ground that, to the extent that prices are sticky in local currency, the exchange rate does not play the stabilizing role envisioned by the received wisdom. An important question is whether, for this very reason, stabilization policies should limit exchange rate movements, or even eliminate them altogether. In this paper, I re-assess this issue by extending the Corsetti and Pesenti (2001) model to allow for home bias in consumption, so that I can exploit the advantages of closed-form solutions. While this extension leaves most properties of the model unaffected, home bias implies that the real exchange rate in an efficient equilibrium is not constant, but fluctuates with the terms of trade. The weight that monetary authorities optimally place on stabilizing domestic marginal costs is increasing in Home bias. With asymmetric shocks, fixed exchange rates are incompatible with efficient monetary rules. Yet, the adverse welfare consequences of exchange rate movements constrain the optimal intensity of monetary responses to domestic shocks. Openness matters: the larger the import content of consumption, the lower the exchange rate volatility implied by optimal stabilization rules.

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Paper provided by European University Institute in its series Economics Working Papers with number ECO2005/21.

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Date of creation: 2005
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Handle: RePEc:eui:euiwps:eco2005/21
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  6. Giancarlo Corsetti & Paolo Pesenti, 2005. "The Simple Geometry of Transmission and Stabilization in Closed and Open Economies," NBER Working Papers 11341, National Bureau of Economic Research, Inc.
  7. Obstfeld, Maurice & Rogoff, Kenneth, 2001. "Global Implications of Self-Oriented National Monetary Rules," Center for International and Development Economics Research, Working Paper Series qt6412m5b7, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  8. Sutherland, Alan, 2002. "Incomplete Pass-Through and the Welfare Effects of Exchange Rate Variability," CEPR Discussion Papers 3431, C.E.P.R. Discussion Papers.
  9. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach," American Economic Review, American Economic Association, vol. 91(2), pages 248-252, May.
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  13. Devereux, Michael B. & Engel, Charles, 2006. "Expenditure switching vs. real exchange rate stabilization: competing objectives for exchange rate policy," Working Paper Series 0614, European Central Bank.
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  17. Giancarlo Corsetti & Paolo Pesenti, 1997. "Welfare and Macroeconomic Interdependence," NBER Working Papers 6307, National Bureau of Economic Research, Inc.
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  19. Duarte, Margarida & Obstfeld, Maurice, 2008. "Monetary policy in the open economy revisited: The case for exchange-rate flexibility restored," Journal of International Money and Finance, Elsevier, vol. 27(6), pages 949-957, October.
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