Expenditure switching versus real exchange rate stabilization - competing objectives for exchange rate policy

Michael B. Devereux () and Charles Engel ()

No 614, Working Paper Series from European Central Bank

Abstract: This paper develops a view of exchange rate policy as a trade-off between the desire to smooth fluctuations in real exchange rates so as to reduce distortions in consumption allocations, and the need to allow flexibility in the nominal exchange rate so as to facilitate terms of trade adjustment. We show that optimal nominal exchange rate volatility will reflect these competing objectives. The key determinants of how much the exchange rate should respond to shocks will depend on the extent and source of price stickiness, as well as the elasticity of substitution between home and foreign goods. Quantitatively, we find the optimal exchange rate volatility should be significantly less than would be inferred based solely on terms of trade considerations. Moreover, we find that the relationship between price stickiness and optimal exchange rate volatility may be non-monotonic. JEL Classification: F41; E52.

Keywords: Exchange rates; monetary policy; expenditure switching. (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-fmk, nep-mac and nep-mon
Date: 2006-04
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Related works:
Journal Article: Expenditure switching versus real exchange rate stabilization: Competing objectives for exchange rate policy (2007)
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