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 focus on the extent to which monetary policy should be employed in stabilising 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 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 pricing, we find that optimal monetary policy in response to real shocks 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 is strengthened in the presence of local-currency pricing. We thank an anonymous referee for very helpful comments on an earlier draft. We have also benefited greatly from comments by a large number of our colleagues in the profession. Engel acknowledges assistance from a National Science Foundation grant to the National Bureau of Economic Research. Devereux thanks the Social Sciences and Humanities Research Council of Canada for financial assistance. This paper was completed when Devereux was visiting the HKIMR. He thanks the institute for its hospitality. The views presented in this paper are those of the authors and do not necessarily reflect those of the Hong Kong Institute for Monetary Research, its Council of Advisors or Board of Directors.