Exchange Rate Policy and Endogenous Price Flexibility

Michael Devereux

No 4121, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: A fixed exchange rate limits the ability of the real exchange rate to adjust to shocks, and tends to raise the volatility of real GDP. But adjustment may be enhanced if internal prices are more flexible under a fixed exchange rate. This Paper develops a model in which price setters incur a cost to retain the option of ex-post price flexibility. The benefit of flexibility is increasing in the variance of demand facing price-setters. We ask whether fixing the exchange rate is likely to increase price flexibility. For a unilateral peg followed by one country alone, the answer is yes. Moreover, because there is a strategic complementarity in the choice of price flexibility, the increase in flexibility following an exchange rate peg can be very large. It is even possible that the increase in internal flexibility following an exchange rate peg is so great that it overturns the direct effect, and GDP is more stable after a peg. On the other hand, when an exchange rate peg is supported by bilateral participation of both monetary authorities (such as a monetary union), the degree of price flexibility may actually be less than under freely floating exchange rates. The model also allows for multiple, self-fulfilling equilibria in the degree of price flexibility.

Keywords: exchange rate; Sticky prices (search for similar items in EconPapers)
JEL-codes: E50 F40 (search for similar items in EconPapers)
Date: 2003-11
New Economics Papers: this item is included in nep-dge and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
https://cepr.org/publications/DP4121 (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cpr:ceprdp:4121

Ordering information: This working paper can be ordered from
https://cepr.org/publications/DP4121

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers Centre for Economic Policy Research, 33 Great Sutton Street, London EC1V 0DX.
Bibliographic data for series maintained by ().