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The Optimal Choice of Exchange-Rate Regime: Price-Setting Rules and Internationalized Production

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  • Michael Devereux
  • Charles Engel
Abstract
We investigate the choice of exchange-rate regime fixed or floating in a dynamic, intertemporal general equilibrium framework. Our framework extends Devereux and Engel (1998) by investigating the implications of internationalized production. We examine the role of price-setting -- whether prices are set in the currency of producers or the currency of consumers in determining the optimality of exchange-rate regimes in an environment of uncertainty created by monetary shocks. We find that when prices are set in producers' currencies, floating exchange rates are preferred when the country is large enough, or not too risk averse. On the other hand, floating exchange rates are always preferred when prices are set in consumers' currencies because floating exchange rates allow domestic consumption to be insulated from foreign monetary shocks. The gains from floating exchange rates are greater when there is internationalized production in this case.
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Suggested Citation

  • Michael Devereux & Charles Engel, 2000. "The Optimal Choice of Exchange-Rate Regime: Price-Setting Rules and Internationalized Production," Discussion Papers in Economics at the University of Washington 0022, Department of Economics at the University of Washington.
    • Handle: RePEc:fth:washer:0022
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    JEL classification:

    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General
    • F20 - International Economics - - International Factor Movements and International Business - - - General

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