Expenditure Switching vs. Real Exchange Rate Stabilization: Competing Objectives for Exchange Rate Policy
Michael B. Devereux
University of British Columbia (UBC) - Department of Economics; Centre for Economic Policy Research (CEPR)
Charles M. Engel
University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics
ECB Working Paper No. 614
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, as well as the elasticity of substitution between home and foreign goods. 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.
Number of Pages in PDF File: 49
Keywords: Exchange rates, monetary policy, expenditure switching
JEL Classification: F41, E52
Date posted: May 22, 2006
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