Working Paper: CEPR ID: DP4121
Authors: Michael B. Devereux
Abstract: A fixed exchange rate limits the ability of the real exchange rate to adjust to shocks, and tends to raise the volatility of real GDP. But adjustment may be enhanced if internal prices are more flexible under a fixed exchange rate. This Paper develops a model in which price setters incur a cost to retain the option of ex-post price flexibility. The benefit of flexibility is increasing in the variance of demand facing price-setters. We ask whether fixing the exchange rate is likely to increase price flexibility. For a unilateral peg followed by one country alone, the answer is yes. Moreover, because there is a strategic complementarity in the choice of price flexibility, the increase in flexibility following an exchange rate peg can be very large. It is even possible that the increase in internal flexibility following an exchange rate peg is so great that it overturns the direct effect, and GDP is more stable after a peg. On the other hand, when an exchange rate peg is supported by bilateral participation of both monetary authorities (such as a monetary union), the degree of price flexibility may actually be less than under freely floating exchange rates. The model also allows for multiple, self-fulfilling equilibria in the degree of price flexibility.
Keywords: exchange rate; sticky prices
JEL Codes: E50; F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| unilateral peg (F16) | price flexibility (D41) |
| nominal demand volatility (C69) | price flexibility (D41) |
| bilateral peg (F16) | price flexibility (D41) |
| exchange rate policy (F31) | price flexibility (D41) |
| strategic complementarity (D10) | price flexibility (D41) |
| environmental changes (O44) | price adjustment behavior (D40) |