Working Paper: NBER ID: w7665
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, 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
JEL Codes: F3; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal monetary policy in response to real country-specific shocks (E63) | fixed exchange rates when local-currency pricing is prevalent (F31) |
| producer-currency pricing (F31) | exchange rate flexibility is essential for achieving necessary adjustments in relative prices due to real shocks (F31) |
| local-currency pricing (F31) | link between exchange rates and nominal price adjustments weakens (F31) |
| prevalence of local-currency pricing (F31) | optimal policy does not rely on exchange rate adjustments (F31) |
| stable monetary sector (E63) | favor a floating exchange rate under local-currency pricing (F31) |