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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 examine the optimal monetary policy under commitment, focusing on the nature of price adjustment in determining policy. We investigate the implications of these policies for exchange-rate flexibility. 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 the 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 (LCP) in industrialized countries—the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of LCP, we find that the optimal monetary policy leads to a fixed exchange rate, even in the presence of country-specific shocks. This is true whether monetary policy is chosen cooperatively or non-cooperatively among countries. Copyright 2003, Wiley-Blackwell.

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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. Charles Engel, 1995. "Accounting for U.S. Real Exchange Rate Changes," NBER Working Papers 5394, National Bureau of Economic Research, Inc.
  2. Svensson, L.E.O., 1998. "Open-Economy Inflation Targeting," Papers 638, Stockholm - International Economic Studies.
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  4. Michael Devereux & Charles Engel & Cedric Tille, 1999. "Exchange-Rate Pass-Through and the Welfare Effects of the Euro," Discussion Papers in Economics at the University of Washington 0034, Department of Economics at the University of Washington.
  5. Charles Engel, 1992. "Real Exchange Rates and Relative Prices: An Empirical Investigation," NBER Working Papers 4231, National Bureau of Economic Research, Inc.
  6. 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.
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  8. Philippe Bacchetta & Eric van Wincoop, 1998. "Does exchange rate stability increase trade and capital flows?," Research Paper 9818, Federal Reserve Bank of New York.
  9. Maurice Obstfeld & Kenneth Rogoff, 2000. "New Directions for Stochastic Open Economy Models," International Finance 0004002, EconWPA.
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  11. 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.
  12. Charles Engel & John H. Rogers, 1995. "How wide is the border?," Research Working Paper 95-09, Federal Reserve Bank of Kansas City.
  13. 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.
  14. Maurice Obstfeld & Kenneth Rogoff, 1994. "Exchange Rate Dynamics Redux," NBER Working Papers 4693, National Bureau of Economic Research, Inc.
  15. Obstfeld, M., 1998. "Risk and Exchange Rate," Papers 193, Princeton, Woodrow Wilson School - Public and International Affairs.
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  19. 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.
  20. 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.
  21. 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.
  22. Maurice Obstfeld, 1999. "Open-Economy Macroeconomics, Developments in Theory and Policy," NBER Working Papers 6319, National Bureau of Economic Research, Inc.
  23. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
  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. 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.
  26. Maurice Obstfeld, 1997. "Europe's gamble," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 28(2), pages 241-317.
  27. Yushi Yoshida & Shinji Takagi, 1999. "Exchange Rate Movements and Tradable Goods Prices in East Asia: An Analysis Based on Japanese Customs Data, 1988-98," IMF Working Papers 99/31, International Monetary Fund.
  28. 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.
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