Journal Article

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

Michael B. Devereux and Charles Engel

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 70, issue 4, pages 765-783
Published in print October 2003 | ISSN: 0034-6527
Published online October 2003 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/1467-937X.00266
Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility

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  • Macroeconomic Aspects of International Trade and Finance
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This paper develops a welfare-based model of monetary policy in an open economy. We examine the optimal monetary policy under commitment, focusing on the nature of price adjustment in determining policy. We investigate the implications of these policies for exchange-rate flexibility. 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 (LCP) in industrialized countries—the expenditure-switching role played by nominal exchange rates may be exaggerated in the traditional literature. In the presence of LCP, we find that the optimal monetary policy leads to a fixed exchange rate, even in the presence of country-specific shocks. This is true whether monetary policy is chosen cooperatively or non-cooperatively among countries.

Keywords: E31; E52; F31; F41

Journal Article.  9693 words.  Illustrated.

Subjects: Macroeconomic Aspects of International Trade and Finance ; Prices, Business Fluctuations, and Cycles ; Monetary Policy, Central Banking, and the Supply of Money and Credit ; International Finance

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