Working Paper: NBER ID: w12215
Authors: Michael B. Devereux; Charles Engel
Abstract: This paper develops a view of exchange rate policy as a trade-off between the desire to smooth fluctuations in real exchange rates so as to reduce distortions in consumption allocations, and the need to allow flexibility in the nominal exchange rate so as to facilitate terms of trade adjustment. We show that optimal nominal exchange rate volatility will reflect these competing objectives. The key determinants of how much the exchange rate should respond to shocks will depend on the extent and source of price stickiness, the elasticity of substitution between home and foreign goods, and the amount of home bias in production. Quantitatively, we find the optimal exchange rate volatility should be significantly less than would be inferred based solely on terms of trade considerations. Moreover, we find that the relationship between price stickiness and optimal exchange rate volatility may be non-monotonic.
Keywords: Exchange Rate Policy; Real Exchange Rate; Terms of Trade; Price Stickiness
JEL Codes: F3; F4; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal nominal exchange rate volatility (F31) | optimal exchange rate movements do not deliver full terms of trade adjustment (F31) |
| price stickiness (L11) | optimal nominal exchange rate volatility (F31) |
| elasticity of substitution (D11) | optimal nominal exchange rate volatility (F31) |
| nominal prices of traded goods are slow to adjust (F16) | inefficient movements in real exchange rates (F31) |
| production functions for final consumption goods are identical across countries (E23) | optimal real exchange rate is constant (F31) |
| optimal policy stabilizes real exchange rates relative to terms of trade (F31) | conflicts with need for terms of trade adjustment (F14) |
| low short-run elasticity of substitution for imports (F14) | little expenditure switching when nominal exchange rates change (F31) |
| optimal monetary policy will limit exchange rate volatility substantially (E63) | relative to that required to achieve terms of trade volatility in a frictionless economy (F12) |