Contrasting Different Forms of Price Stickiness: An Analysis of Exchange Rate Overshooting and the Beggar Thy Neighbour Policy

This paper considers a two country economy similar to that in Obstfeld and Rogoff (1995). We build on their model by distinguishing between sticky retail prices, sticky wholesale prices and sticky wages. We find that conclusions about whether monetary shocks lead to exchange rate overshooting and spillovers on foreign production and consumption depend crucially on the form of price stickiness assumed in the economy. Sticky retail prices not only allow for a profitable Beggar Thy Neighbour Policy but also lead to exchange rate overshooting. Although the outcome is similar to the seminal work by Dornbusch (1976), the driving force in our model is quite different. With sticky retail prices, the exchange rate overshoots even though the interest rate parity may not even hold in equilibrium. These results are in sharp contrast to the outcomes under the sticky wholesale prices scenario wherein prices are fixed in the producers currency. Contrary to the spirit of the Beggar Thy Neighbour Policy, an unexpected money expansion benefits inhabitants in the other country as well. The interest rate parity always hold in equilibrium and there is no exchange rate overshooting.