Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility

45 Pages Posted: 17 May 2000 Last revised: 2 Apr 2001

See all articles by Michael B. Devereux

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

Multiple version iconThere are 2 versions of this paper

Date Written: April 2000

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.

Suggested Citation

Devereux, Michael B. and Engel, Charles M., Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility (April 2000). NBER Working Paper No. w7665. Available at SSRN: https://ssrn.com/abstract=228139

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR)

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Charles M. Engel (Contact Author)

University of Wisconsin - Madison - Department of Economics ( email )

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University of Washington - Department of Economics ( email )

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