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Expenditure Switching vs. Real Exchange Rate Stabilization: Competing Objectives for Exchange Rate Policy

  • Michael B. Devereux
  • Charles Engel

This paper develops a view of exchange rate policy as a trade-off between the desire to smooth fluctuations in real exchange rates so as to reduce distortions in consumption allocations, and the need to allow flexibility in the nominal exchange rate so as to facilitate terms of trade adjustment. We show that optimal nominal exchange rate volatility will reflect these competing objectives. The key determinants of how much the exchange rate should respond to shocks will depend on the extent and source of price stickiness, the elasticity of substitution between home and foreign goods, and the amount of home bias in production. Quantitatively, we find the optimal exchange rate volatility should be significantly less than would be inferred based solely on terms of trade considerations. Moreover, we find that the relationship between price stickiness and optimal exchange rate volatility may be non-monotonic.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 12215.

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Date of creation: May 2006
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Publication status: published as Devereux, Michael B. and Charles Engel. “Expenditure Switching vs. Real Exchange Rate Stabilization: Competing Objectives for Exchange-Rate Policy.” Journal of Monetary Economics 54 (2007): 2346-2374.
Handle: RePEc:nbr:nberwo:12215
Note: IFM
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  23. Parsley, David C. & Wei, Shang-Jin, 2001. "Explaining the border effect: the role of exchange rate variability, shipping costs, and geography," Journal of International Economics, Elsevier, vol. 55(1), pages 87-105, October.
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