Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime

Michael Devereux and Charles Engel

No 6867, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We investigate the welfare properties of fixed and floating exchange rate regimes in a two-country, dynamic, infinite-horizon model with agents optimizing in an environment of uncertainty created by monetary shocks. The optimal exchange rate regime may depend on whether prices are set in the currency of producers or the currency of consumers. When prices are set in consumers' currency, the variance of home consumption is not influenced by foreign monetary variance under floating exchange rates, while there is transmission of foreign disturbances under floating rates if prices are set in producers' currencies, or under fixed exchange rates. An important feature of the model is the exchange rate regime affects not just the variance of consumption and output, but also their average levels. When prices are set in producer's currency, as in the traditional framework, we find that there is a trade-off between floating and fixed exchange rates. Exchange rate adjustment under floating rates allows for a lower variance of consumption, but exchange rate volatility itself leads to a lower average level of consumption. When prices are set in consumer's currency, floating exchange rates always dominate fixed exchange rates.

JEL-codes: F3 F4 (search for similar items in EconPapers)
Date: 1998-12
New Economics Papers: this item is included in nep-dge
Note: IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (166)

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