Working Paper: CEPR ID: DP2900
Authors: Michael B. Devereux
Abstract: A classic argument for flexible exchange rates is that the exchange rate plays a ?shock-absorber' role in an open economy hit by country specific shocks. This Paper presents a sharp counterexample to this argument within a very simple open economy model. Countries are subject to unpredictable shocks to world demand for their goods. Efficient adjustment is prevented, both by sticky nominal wages and by the absence of a market for hedging consumption risk across countries. A flexible exchange rate policy, by stabilizing domestic prices, fully stabilizes output and replicates the flexible wage outcome, acting perfectly as a ?shock absorber?. Despite this, a policy that fixes the exchange rate may be welfare superior, even though fixed exchange rates cause GDP to fluctuate away from the flexible wage outcome. Moreover, an optimal monetary rule in this environment would always dampen exchange rate movements, and may even be a fixed exchange rate.
Keywords: fixed exchange rates; flexible exchange rates; risk sharing
JEL Codes: E50; F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Flexible Exchange Rates (F31) | Stabilization of Employment and Output (E63) |
| Fixed Exchange Rates (F31) | Welfare Outcomes (I38) |
| Monetary Policy Decisions (E52) | Exchange Rate Stability (F31) |
| Flexible Exchange Rates (F31) | Economic Stability (E64) |
| Fixed Exchange Rates (F31) | GDP Fluctuations (F44) |