Working Paper: CEPR ID: DP2454
Authors: Michael B. Devereux; Charles Engel
Abstract: 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 maintaining 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 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 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 pricing 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 (a monetary policy in which exchange rates are not a consideration) is strengthened in the presence of local-currency pricing.
Keywords: Monetary Policy; Exchange Rates; Local Currency Pricing; Producer Currency Pricing
JEL Codes: F33; F41; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| producer currency pricing (PCP) (F31) | exchange rate movements (F31) |
| exchange rate movements (F31) | optimal monetary policy (E63) |
| local currency pricing (LCP) (F31) | no effect of exchange rate movements on optimal monetary policy (F31) |
| large domestic monetary shocks (E19) | preference for stability from a country with strong monetary discipline (E63) |
| producer currency pricing (PCP) (F31) | optimal monetary policy requires exchange rate flexibility (F31) |
| local currency pricing (LCP) (F31) | floating exchange rate is optimal (F31) |