The Optimal Choice of Exchange Rate Regime

Michael B. Devereux and Charles Engel

in Topics in Empirical International Economics

Published by University of Chicago Press

Published in print April 2001 | ISBN: 9780226060835
Published online February 2013 | e-ISBN: 9780226060859 | DOI:
The Optimal Choice of Exchange Rate Regime

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A country can be insulated to some degree from foreign demand shocks under floating exchange rates because relative price movements absorb some of the changes in demand that would have to be met by changes in quantities produced under fixed exchange rates. Several of the chapters here evaluate the optimality of exchange rate regimes on ad hoc criteria, generally involving variance of output and inflation. Others investigate the welfare properties of alternative exchange rate systems, but do not assume any sort of nominal price stickiness. This chapter examines the optimality of exchange rate regimes from a welfare maximization standpoint using a two-country, infinite horizon model of optimization under uncertainty. Consumers get utility from consumption, leisure, and real balances. The chapter assumes perfect capital mobility in the model because it allows a complete market of state-contingent nominal bonds. The sources of uncertainty are random monetary shocks at home and abroad. The chapter also assumes that monopolistic firms must set nominal prices prior to the realization of monetary shocks.

Keywords: exchange rates; optimality; welfare; consumption; leisure; real balances; nominal bonds; monetary shocks; nominal prices

Chapter.  13327 words. 

Subjects: International Economics

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