Real Exchange Rate and Output Variability: The Role of Sticky Prices

Abstract

This paper investigates the relationships between the degree of price stickiness (inflexibility), the variability of output, and that of the real exchange rate in an open economy under flexible exchange rates and capital mobility. We show that there exists, in general, a critical degree of price inflexibility below which increased inflexibility of prices reduces the variability of output. We also show that, in general, as prices become more inflexible, the relationship between the variability of the real exchange rate and that of output will be nonmonotonic. That is, as the variability of the real exchange rate increases the variability of output will decline up to a point, and only then increase.

JEL Classification: 0230, 4000, 4314