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

  • 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
Date of revision:
Handle: RePEc:hkm:wpaper:042000
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  1. Philippe Bacchetta & Eric Van Wincoop, 1998. "Does Exchange Rate Stability Increase Trade and Capital Flows?," NBER Working Papers 6704, National Bureau of Economic Research, Inc.
  2. Charles Engel, 1992. "Real Exchange Rates and Relative Prices: An Empirical Investigation," NBER Working Papers 4231, National Bureau of Economic Research, Inc.
  3. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare And Macroeconomic Interdependence," The Quarterly Journal of Economics, MIT Press, vol. 116(2), pages 421-445, May.
  4. Charles Engel & John H. Rogers, 1994. "How Wide is the Border?," NBER Working Papers 4829, National Bureau of Economic Research, Inc.
  5. McCallum, Bennett T. & Nelson, Edward, 1998. "Nominal Income Targeting in an Open-Economy Optimizing Model," Seminar Papers 644, Stockholm University, Institute for International Economic Studies.
  6. Michael Devereux & Charles Engel & Cedric Tille, 1999. "Exchange-Rate Pass-Through and the Welfare Effects of the Euro," Working Papers 0034, University of Washington, Department of Economics.
  7. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "New directions for stochastic open economy models," Journal of International Economics, Elsevier, vol. 50(1), pages 117-153, February.
  8. 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.
  9. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-60, June.
  10. Engel, C., 1996. "Accounting for U.S. Real Exchange Rate Changes," Discussion Papers in Economics at the University of Washington 96-02, Department of Economics at the University of Washington.
  11. Lars E. O. Svensson, 2000. "Open-Economy Inflation Targeting," NBER Working Papers 6545, National Bureau of Economic Research, Inc.
  12. Atish R. Ghosh & Anne-Marie Gulde & Jonathan D. Ostry & Holger C. Wolf, 1997. "Does the Nominal Exchange Rate Regime Matter?," NBER Working Papers 5874, National Bureau of Economic Research, Inc.
  13. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
  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. 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.
  16. Maurice Obstfeld, 1999. "Open-Economy Macroeconomics, Developments in Theory and Policy," NBER Working Papers 6319, National Bureau of Economic Research, Inc.
  17. Maurice Obstfeld, 1997. "Europe's gamble," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 28(2), pages 241-317.
  18. By Shinji Takagi & Yushi Yoshida, 2001. "Exchange Rate Movements and Tradable Goods Prices in East Asia: An Analysis Based on Japanese Customs Data, 1988–1999," IMF Staff Papers, Palgrave Macmillan, vol. 48(2), pages 266-289.
  19. 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.
  20. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1997. "Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Business Cycles," NBER Working Papers 5876, National Bureau of Economic Research, Inc.
  21. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1987. "International real business cycles," Working Papers 426, Federal Reserve Bank of Minneapolis.
  22. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
  23. 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.
  24. Betts, Caroline & Devereux, Michael B, 2000. "International Monetary Policy Coordination and Competitive Depreciation: A Reevaluation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 722-45, November.
  25. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
  26. Harold L. Cole & Maurice Obstfeld, 1989. "Commodity Trade and International Risk Sharing: How Much Do Financial Markets Matter?," NBER Working Papers 3027, National Bureau of Economic Research, Inc.
  27. Maurice Obstfeld & Kenneth Rogoff, 1998. "Risk and Exchange Rates," NBER Working Papers 6694, National Bureau of Economic Research, Inc.
  28. 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.
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