A Simple Dynamic General Equilibrium Analysis of the Trade-off Between Fixed and Floating Exchange Rates

This paper provides a complete analytical characterization of the positive and normative effects of alternative exchange rate regimes in a simple two-country sticky-price dynamic general equilibrium model with money, technology, and government spending shocks. A central question addressed is whether fixing the exchange rate prevents macroeconomic adjustment in relative prices from occurring, in face of shocks. In the model, the exchange rate regime has implications for both the volatility and mean of macroeconomic aggregates. But the effects of the exchange rate regime depend upon both the stance of monetary policy and the way in which the exchange rate is pegged. With a passive monetary policy, a cooperative pegged exchange rate regime has no implications for macroeconomic volatility, relative to a floating regime, but implies a higher mean level of employment, capital stock, and real GDP. When monetary policy is determined optimally however, a fixed exchange rate regime leads to higher employment volatility and a lower mean level of employment and real GDP. Therefore, whether fixing the exchange rate involves a welfare cost depends critically upon the flexibility of monetary policy in responding to macroeconomic shocks.