Monetary policy rules and exchange rate flexibility in a simple dynamic general equilibrium model

Abstract

This paper provides a complete analytical characterization of the positive and normative effects of alternative exchange rate regimes in a simple two-country sticky-price dynamic general equilibrium model with multiple shocks. A central question addressed is whether fixing the exchange rate prevents macroeconomic adjustment in relative prices from occurring. We find that in general, allowing the exchange rate to float does not facilitate relative price adjustment, in face of country-specific shocks. In a comparison of monetary policy rules which allow for differential degrees of exchange rate targeting, it is found that a rule in which both countries engage in a cooperative exchange rate peg welfare-dominates a rule which allows the exchange rate to float endogenously (as well as a one-sided peg). When optimal monetary rules can target both employment and exchange rates however, a cooperative exchange rate peg leads to lower welfare. Therefore, whether fixing the exchange rate involves a welfare cost depends critically upon the way in which monetary rules are designed. Quantitatively, we find that the welfare differences across different monetary rules (exchange rate regimes) are very small.