Working Paper: NBER ID: w25111
Authors: Sihao Chen; Michael B. Devereux; Jenny Xu; Kang Shi
Abstract: Empirical evidence suggests that for many countries, retail prices of traded goods are sticky in national currencies. Movements in exchange rates then cause deviations from the law of one price, and exchange rate ëmisalignmentí, which cannot be corrected by monetary policy alone. This paper shows that a state contingent international tax policy can be combined with monetary policy to eliminate exchange rate misalignment and sustain a fully efficient welfare outcome. But this monetary-fiscal mix cannot be decentralized with non-cooperative determination of monetary and fiscal policy. Non-cooperative use of taxes and subsidies introduces strategic spillovers which opens up a fundamental conflict between the goals of output gap and inflation stabilization and those of terms of trade manipulation in an open economy. The implementation of an efficient monetary-fiscal mix requires effective cooperation in fiscal policy, while leaving monetary policy to be determined non-cooperatively. In addition, while an efficient outcome requires state contingent taxes and subsidies to eliminate exchange rate misalignment, it is still necessary to have flexible exchange rates and independent monetary policy.
Keywords: Exchange Rates; Local Currency Pricing; International Tax Policies
JEL Codes: F3; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| state-contingent international tax policy (F38) | exchange rate misalignment (F31) |
| optimal tax policies (H21) | relative price movements (E30) |
| optimal tax policy (H21) | correction of relative prices (P22) |
| effective fiscal policies (E62) | benefits of flexible exchange rates (F31) |
| independent monetary policy (E58) | producer price inflation (E31) |
| non-cooperative policymaking (D70) | lack of equilibrium (D50) |
| cooperation in fiscal policy (F42) | efficient outcomes (D61) |