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Expenditure Switching vs. Real Exchange Rate Stabilization: Competing Objectives for Exchange Rate Policy

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  • Michael B. Devereux
  • Charles Engel
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, the elasticity of substitution between home and foreign goods, and the amount of home bias in production. 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.

Suggested Citation

  • Michael B. Devereux & Charles Engel, 2006. "Expenditure Switching vs. Real Exchange Rate Stabilization: Competing Objectives for Exchange Rate Policy," NBER Working Papers 12215, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:12215
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    Cited by:

    1. Pang, Ke, 2013. "Financial integration, nominal rigidity, and monetary policy," International Review of Economics & Finance, Elsevier, vol. 25(C), pages 75-90.
    2. Giancarlo Corsetti & Luca Dedola & Sylvain Leduc, 2007. "Optimal Monetary Policy and the Sources of Local-Currency Price Stability," NBER Chapters, in: International Dimensions of Monetary Policy, pages 319-367, National Bureau of Economic Research, Inc.
    3. Olivier Blanchard, 2007. "Current Account Deficits in Rich Countries," IMF Staff Papers, Palgrave Macmillan, vol. 54(2), pages 191-219, June.
    4. Vladimir Sokolov & Byung‐Joo Lee & Nelson C. Mark, 2011. "Linkages Between Exchange Rate Policy And Macroeconomic Performance," Pacific Economic Review, Wiley Blackwell, vol. 16(4), pages 395-420, October.
    5. Vitale, Paolo, 2006. "A Market Microstructure Analysis of Foreign Exchange Intervention," CEPR Discussion Papers 5468, C.E.P.R. Discussion Papers.
    6. Darracq Pariès, Matthieu, 2007. "International frictions and optimal monetary policy cooperation: analytical solutions," Working Paper Series 834, European Central Bank.
    7. Corsetti, Giancarlo, 2006. "Openness and the case for flexible exchange rates," Research in Economics, Elsevier, vol. 60(1), pages 1-21, March.
    8. Liao, Wei & Shi, Kang & Zhang, Zhiwei, 2012. "Vertical trade and China's export dynamics," China Economic Review, Elsevier, vol. 23(4), pages 763-775.
    9. Lucas FERRERO & Carlos Matías HISGEN, 2014. "Determinants of exports intensity of industrial SMEs in Argentina," Regional and Sectoral Economic Studies, Euro-American Association of Economic Development, vol. 14(2).
    10. Enrique Martínez García, 2007. "A monetary model of the exchange rate with informational frictions," Globalization Institute Working Papers 02, Federal Reserve Bank of Dallas.
    11. Devereux, Michael B. & Shi, Kang & Xu, Juanyi, 2007. "Global monetary policy under a dollar standard," Journal of International Economics, Elsevier, vol. 71(1), pages 113-132, March.
    12. Sweidan Osama D., 2013. "Exchange Rate Pass-Through into Import Prices in Jordan," Global Economy Journal, De Gruyter, vol. 13(1), pages 109-128, January.
    13. Thorvardur Tjörvi Ólafsson, 2006. "The New Keynesian Phillips Curve: In Search of Improvements and Adaptation to the Open Economy," Economics wp31_tjorvi, Department of Economics, Central bank of Iceland.
    14. Olivier Blanchard, 2007. "Current Account Deficits in Rich Countries," IMF Staff Papers, Palgrave Macmillan, vol. 54(2), pages 191-219, June.

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    JEL classification:

    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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