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

  • Michael Devereux
  • Charles Engel

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 University of Washington, Department of Economics in its series Working Papers with number 0016.

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Date of creation: Apr 2000
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Handle: RePEc:udb:wpaper:0016
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  1. Obstfeld, M., 1998. "Risk and Exchange Rate," Papers 193, Princeton, Woodrow Wilson School - Public and International Affairs.
  2. Charles Engel & John H. Rogers, 1994. "How Wide is the Border?," NBER Working Papers 4829, National Bureau of Economic Research, Inc.
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  4. 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.
  5. 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.
  6. Michael B. Devereux & Charles Engel & Cedric Tille, 1999. "Exchange Rate Pass-Through and the Welfare Effects of the Euro," NBER Working Papers 7382, National Bureau of Economic Research, Inc.
  7. Maurice Obstfeld & Kenneth Rogoff, 1999. "New Directions for Stochastic Open Economy Models," NBER Working Papers 7313, National Bureau of Economic Research, Inc.
  8. Charles Engel, 1992. "Real Exchange Rates and Relative Prices: An Empirical Investigation," NBER Working Papers 4231, National Bureau of Economic Research, Inc.
  9. Atish R. Ghosh & Anne-Marie Gulde & Jonathan D. Ostry & Holger C. Wolf, 1997. "Does The Nominal Exchange Rate Regime Matter?," Working Papers 97-09, New York University, Leonard N. Stern School of Business, Department of Economics.
  10. Bacchetta, Philippe & van Wincoop, Eric, 1998. "Does Exchange Rate Stability Increase Trade and Capital Flows?," CEPR Discussion Papers 1962, C.E.P.R. Discussion Papers.
  11. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1987. "International real business cycles," Working Papers 426, Federal Reserve Bank of Minneapolis.
  12. 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.
  13. Svensson, Lars E O, 1998. "Open-Economy Inflation Targeting," CEPR Discussion Papers 1989, C.E.P.R. Discussion Papers.
  14. 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.
  15. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 553-578, June.
  16. Yushi Yoshida & Shinji Takagi, 1999. "Exchange Rate Movements and Tradable Goods Prices in East Asia; An Analysis Basedon Japanese Customs Data, 1988-1998," IMF Working Papers 99/31, International Monetary Fund.
  17. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
  18. 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.
  19. 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.
  20. 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.
  21. Maurice Obstfeld, 1997. "Open-Economy Macroeconomics: Developments in Theory and Policy," Working Papers 958, Queen's University, Department of Economics.
  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. 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.
  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. 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.
  26. 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.
  27. 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.
  28. Maurice Obstfeld, 1997. "Europe's gamble," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 28(2), pages 241-317.
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