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Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility

Listed author(s):
  • Michael B. Devereux

    (University of British Columbia, CEPR)

  • Charles Engel

    (University of Washington and NBER)

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 stabilising 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 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 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 is strengthened in the presence of localcurrency pricing.

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Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 042000.

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Length: 33 pages
Date of creation: Jul 2000
Handle: RePEc:hkm:wpaper:042000
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