Exchange Rate Regimes and the Real Exchange Rate

Abstract

It is well established now that the (nominal) exchange rate regime has important implications for the behavior of real exchange rates. Two key stylized facts in this regard are that real exchange rate variability is greater under flexible exchange rates than under fixed exchange rates and that real and nominal exchange rate movements are positively related under flexible exchange rates. One class of models that are consistent with these observations are sticky price models. This paper constructs an equilibrium model of real and nominal exchange rate determination that is capable of explaining these observed facts without resorting to differences in other policies across regimes. The paper thus shows that there is an inherent tendency, due solely to the difference in monetary adjustment mechanisms across alternative exchange rate regimes, for real exchange rates to exhibit greater variability under flexible exchange rates and this tendency turns out to be compatible with the observed positive correlation between real and nominal exchange rates. The model relies on the inflation tax mechanism and the impact of temporary, country-specific shocks to generate these results.