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

Abstract

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 localcurrency 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. To what extent does independent monetary policy in an open economy require flexibility of the nominal exchange rate? The modern case for flexible exchange rates goes back to Friedman (1953). Real country-specific productivity or demand shocks require adjustment of relative price levels between countries. If nominal prices adjusted quickly, Friedman argues, the choice of exchange-rate regime would be irrelevant because the relative price adjustment could be achieved by nominal price changes: If internal prices were as flexible as exchange rates, it would make little economic difference whether adjustments were brought about by changes in exchange rates or by equivalent changes in internal prices. But this condition is clearly not fulfilled. The exchange rate is potentially flexible in the absence of administrative action to freeze it. At least in the modern world, internal prices are highly inflexible.