The Choice of Exchange-rate Regime in the Framework of New Open Economy Macroeconomics

Abstract

This paper extends the model setup of Devereux and Engel (1998) to investigate how consumption home bias, capital mobility, and price-setting behavior affect the consumption volatility, expected level of consumption, and the welfare performance under alternative exchange rate regimes for a country facing foreign monetary shock. The paper then discusses the issue of the choice of exchange rate regime. According to the analysis of theoretical derivation and simulation, the following conclusions are made. First, the variance of domestic consumption is lowest under a floating exchange rate with pricing-to-market (PTM model for short), and the variance of consumption under floating exchange rate with producer-currency pricing (the PCP model for short) depends on the degree of capital mobility, the share of tradable goods, and the degree of home bias. Secondly, the fixed exchange rate (FER) will dominate the floating exchange rate in terms of the expected level of consumption. Thirdly, from the perspective of welfare performance, a floating exchange rate with pricing-to-market (PTM model) is preferable to a fixed exchange rate. A fixed exchange rate dominates a floating exchange rate with producer-currency pricing (PCP model), and the lower degree of capital mobility induces a higher welfare under fixed exchange rate but a lower welfare under PTM and PCP models.