Working Paper: NBER ID: w9016
Authors: Charles Engel
Abstract: Nominal exchange rate changes can lead to 'expenditure switching' when they change relative international prices. A traditional argument for flexible nominal exchange rates posits that when prices are sticky in producers' currencies, nominal exchange rate movements can change relative prices between home and foreign goods. But if prices are fixed ex ante in consumers' currencies, nominal exchange rate flexibility cannot achieve any relative price adjustment. In that case nominal exchange rate fluctuations have the undesirable feature that they lead to deviations from the law of one price. The case for floating exchange rates is weakened if prices are sticky in this way. The empirical literature appears to support the notion that prices are sticky in consumers' currencies. Here, additional support for this conclusion is provided. We then review some new approaches in the theoretical literature that imply an important expenditure-switching role even when consumer prices are sticky in consumers' currencies. Further empirical research is needed to resolve the quantitative importance of the expenditure-switching role for nominal exchange rates.
Keywords: No keywords provided
JEL Codes: F3; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| nominal exchange rate changes (F31) | expenditure switching (H50) |
| nominal exchange rate changes (F31) | relative price adjustments (P22) |
| sticky consumer prices (E31) | expenditure switching (H50) |
| consumer prices not responsive (E31) | diminished expenditure-switching effect (D12) |
| nominal exchange rate flexibility (F31) | relative price adjustments (P22) |