IDEAS home Printed from https://ideas.repec.org/p/nbr/nberwo/7889.html
   My bibliography  Save this paper

Optimal Exchange Rate Policy: The Influence of Price Setting and Asset Markets

Author

Listed:
  • Charles Engel

Abstract

This paper examines optimal exchange-rate policy in two-country sticky-price general equilibrium models in which households and firms optimize over an infinite horizon in an environment of uncertainty. The models are in the vein of the new open-economy macroeconomics' as exemplified by Obstfeld and Rogoff (1995, 1998, 2000). The conditions under which fixed or floating exchange rates yield higher welfare depend on the exact nature of price stickiness and on the degree of risk-sharing opportunities. This paper presents some preliminary empirical evidence on the behavior of consumer prices in Mexico that suggests failures of the law of one price are important. The evidence on price setting and risk-sharing opportunities is not refined enough to make definitive conclusions about the optimal exchange-rate regime for that country.

Suggested Citation

  • Charles Engel, 2000. "Optimal Exchange Rate Policy: The Influence of Price Setting and Asset Markets," NBER Working Papers 7889, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:7889
    Note: IFM
    as

    Download full text from publisher

    File URL: http://www.nber.org/papers/w7889.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Guillermo A. Calvo & Leonardo Leiderman & Carmen M. Reinhart, 1996. "Inflows of Capital to Developing Countries in the 1990s," Journal of Economic Perspectives, American Economic Association, vol. 10(2), pages 123-139, Spring.
    2. Svensson, Lars E O & van Wijnbergen, Sweder, 1989. "Excess Capacity, Monopolistic Competition, and International Transmission of Monetary Disturbances," Economic Journal, Royal Economic Society, vol. 99(397), pages 785-805, September.
    3. Engel, Charles & Rogers, John H, 1996. "How Wide Is the Border?," American Economic Review, American Economic Association, vol. 86(5), pages 1112-1125, December.
    4. Michael B. Devereux & Charles Engel & CÈdric Tille, 2003. "Exchange Rate Pass-Through and the Welfare Effects of the Euro," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(1), pages 223-242, February.
    5. Charles Engel, 1999. "Accounting for U.S. Real Exchange Rate Changes," Journal of Political Economy, University of Chicago Press, vol. 107(3), pages 507-538, June.
    6. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, April.
    7. Robert A. Mundell, 1960. "The Monetary Dynamics of International Adjustment under Fixed and Flexible Exchange Rates," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 74(2), pages 227-257.
    8. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare and Macroeconomic Interdependence," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 116(2), pages 421-445.
    9. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "New directions for stochastic open economy models," Journal of International Economics, Elsevier, vol. 50(1), pages 117-153, February.
    10. Aizenman, Joshua & Frenkel, Jacob A, 1985. "Optimal Wage Indexation, Foreign Exchange Intervention, and Monetary Policy," American Economic Review, American Economic Association, vol. 75(3), pages 402-423, June.
    11. Bayoumi, Tamim & Eichengreen, Barry, 1998. "Exchange rate volatility and intervention: implications of the theory of optimum currency areas," Journal of International Economics, Elsevier, vol. 45(2), pages 191-209, August.
    12. Jeffrey A. Frankel, 1999. "No Single Currency Regime is Right for All Countries or At All Times," NBER Working Papers 7338, National Bureau of Economic Research, Inc.
    13. Obstfeld, M., 1998. "Risk and Exchange Rate," Papers 193, Princeton, Woodrow Wilson School - Public and International Affairs.
    14. Philippe Bacchetta & Eric van Wincoop, 2000. "Capital Flows to Emerging Markets: Liberalization, Overshooting, and Volatility," NBER Chapters, in: Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies, pages 61-98, National Bureau of Economic Research, Inc.
    15. Kollman, R., 1996. "The Exchange Rate in a Dynamic-Optimizing Current Account Model with Nominal Rigidities: a Quantitative Investigation," Cahiers de recherche 9614, Universite de Montreal, Departement de sciences economiques.
    16. Tamim Bayoumi and Barry Eichengreen., 1993. "One Money or Many? On Analyzing the Prospects for Monetary Unification in Various Parts of the World," Center for International and Development Economics Research (CIDER) Working Papers C93-030, University of California at Berkeley.
    17. Hau, Harald, 2000. "Exchange rate determination: The role of factor price rigidities and nontradeables," Journal of International Economics, Elsevier, vol. 50(2), pages 421-447, April.
    18. Eaton, Jonathan, 1985. "Optimal and time consistent exchange-rate management in an overlapping-generations economy," Journal of International Money and Finance, Elsevier, vol. 4(1), pages 83-100, March.
    19. Barry Eichengreen, 1992. "Is Europe an Optimum Currency Area?," Palgrave Macmillan Books, in: Silvio Borner & Herbert Grubel (ed.), The European Community after 1992, chapter 8, pages 138-161, Palgrave Macmillan.
    20. Stephen J. Turnovsky, 1983. "Wage Indexation and Exchange Market Interventions in a Small Open Economy," Canadian Journal of Economics, Canadian Economics Association, vol. 16(4), pages 574-592, November.
    21. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Stabilization policy and the costs of dollarization," Proceedings, Federal Reserve Bank of Cleveland, pages 482-517.
    22. Willem H. Buiter, 1999. "The EMU and the NAMU: What is the Case for North American Monetary Union?," Canadian Public Policy, University of Toronto Press, vol. 25(3), pages 285-305, September.
    23. Eichengreen, Barry, 1990. "One Money for Europe? Lessons from the US Currency Union," Department of Economics, Working Paper Series qt6ks1k831, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
    24. Weber, Warren E, 1981. "Output Variability under Monetary Policy and Exchange Rate Rules," Journal of Political Economy, University of Chicago Press, vol. 89(4), pages 733-751, August.
    25. Philippe Bacchetta & Eric van Wincoop, 1998. "Does Exchange Rate Stability Increase Trade and Capital Flows?," Working Papers 98.04, Swiss National Bank, Study Center Gerzensee.
    26. Rankin, Neil, 1998. "Nominal rigidity and monetary uncertainty," European Economic Review, Elsevier, vol. 42(1), pages 185-199, January.
    27. Flood, Robert P. & Hodrick, Robert J., 1986. "Real aspects of exchange rate regime choice with collapsing fixed rates," Journal of International Economics, Elsevier, vol. 21(3-4), pages 215-232, November.
    28. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2007. "Business Cycle Accounting," Econometrica, Econometric Society, vol. 75(3), pages 781-836, May.
    29. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
    30. Rankin, Neil, 1998. "Nominal rigidity and monetary uncertainty in a small open economy," Journal of Economic Dynamics and Control, Elsevier, vol. 22(5), pages 679-702, May.
    31. Michael B. Devereux & Charles Engel, 1998. "Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime," NBER Working Papers 6867, National Bureau of Economic Research, Inc.
    32. John H. Rogers & Hayden P. Smith, 2001. "Border effects within the NAFTA countries," International Finance Discussion Papers 698, Board of Governors of the Federal Reserve System (U.S.).
    33. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-660, June.
    34. V. V Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 69(3), pages 533-563.
    35. Helpman, Elhanan, 1981. "An Exploration in the Theory of Exchange-Rate Regimes," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 865-890, October.
    36. Lapan, Harvey E. & Enders, Walter, 1980. "Random disturbances and the choice of exchange regimes in an intergenerational model," Journal of International Economics, Elsevier, vol. 10(2), pages 263-283, May.
    37. Masson,Paul R. & Taylor,Mark P. (ed.), 1993. "Policy Issues in the Operation of Currency Unions," Cambridge Books, Cambridge University Press, number 9780521434553.
    38. Betts, Caroline & Devereux, Michael B., 1996. "The exchange rate in a model of pricing-to-market," European Economic Review, Elsevier, vol. 40(3-5), pages 1007-1021, April.
    39. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1997. "Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Business Cycles," NBER Working Papers 5876, National Bureau of Economic Research, Inc.
    40. Engel, Charles, 2000. "Local-currency pricing and the choice of exchange-rate regime," European Economic Review, Elsevier, vol. 44(8), pages 1449-1472, August.
    41. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August.
    42. repec:bla:econom:v:61:y:1994:i:244:p:407-34 is not listed on IDEAS
    43. Helpman, Elhanan & Razin, Assaf, 1982. "A Comparison of Exchange Rate Regimes in the Presence of Imperfect Capital Markets," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 23(2), pages 365-388, June.
    44. Swati Ghosh & Holger Wolf, 2000. "Is There a Curse of Location? Spatial Determinants of Capital Flows to Emerging Markets," NBER Chapters, in: Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies, pages 137-156, National Bureau of Economic Research, Inc.
    45. Eichengreen, Barry, 1993. "European Monetary Unification," Journal of Economic Literature, American Economic Association, vol. 31(3), pages 1321-1357, September.
    46. Hamada, Koichi & Sakurai, Makoto, 1978. "International Transmission of Stagflation under Fixed and Flexible Exchange Rates," Journal of Political Economy, University of Chicago Press, vol. 86(5), pages 877-895, October.
    47. Barry Eichengreen & Ashoka Mody, 2000. "What Explains Changing Spreads on Emerging Market Debt?," NBER Chapters, in: Capital Flows and the Emerging Economies: Theory, Evidence, and Controversies, pages 107-134, National Bureau of Economic Research, Inc.
    48. Robert P. Flood & Nancy Peregrim Marion, 1982. "The Transmission of Disturbances under Alternative Exchange-Rate Regimes with Optimal Indexing," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 97(1), pages 43-66.
    49. Neumeyer, Pablo Andres, 1998. "Currencies and the Allocation of Risk: The Welfare Effects of a Monetary Union," American Economic Review, American Economic Association, vol. 88(1), pages 246-259, March.
    50. Glick, Reuven & Wihlborg, Clas, 1990. "Real exchange rate effects of monetary shocks under fixed and flexible exchange rates," Journal of International Economics, Elsevier, vol. 28(3-4), pages 267-290, May.
    51. Kimbrough, Kent P., 1983. "The information content of the exchange rate and the stability of real output under alternative exchange-rate regimes," Journal of International Money and Finance, Elsevier, vol. 2(1), pages 27-38, April.
    52. Ghironi, Fabio & Giavazzi, Francesco, 1998. "Currency areas, international monetary regimes, and the employment-inflation tradeoff," Journal of International Economics, Elsevier, vol. 45(2), pages 259-296, August.
    53. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
    54. Turnovsky, Stephen J, 1976. "The Relative Stability of Alternative Exchange Rate Systems in the Presence of Random Disturbances," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 8(1), pages 29-50, February.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    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. Burstein, Ariel T. & Neves, Joao C. & Rebelo, Sergio, 2003. "Distribution costs and real exchange rate dynamics during exchange-rate-based stabilizations," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1189-1214, September.
    3. Fujiki, Hiroshi & Otani, Akira, 2002. "Do Currency Regimes Matter in the 21st Century? An Overview," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 20(S1), pages 47-79, December.
    4. Mathias Hoffmann, 2010. "International financial markets' influence on the welfare performance of alternative exchange rate regimes," Oxford Economic Papers, Oxford University Press, vol. 62(3), pages 442-477, July.
    5. Devereux, Michael B. & Engel, Charles, 2002. "Exchange rate pass-through, exchange rate volatility, and exchange rate disconnect," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 913-940, July.
    6. von Furstenberg, George M., 2006. "Mexico versus Canada: Stability benefits from making common currency with USD?," The North American Journal of Economics and Finance, Elsevier, vol. 17(1), pages 65-78, March.
    7. Shambaugh, Jay, 2008. "A new look at pass-through," Journal of International Money and Finance, Elsevier, vol. 27(4), pages 560-591, June.
    8. Adrian, Tobias & Gros, Daniel, 2004. "The degree of openness and the cost of fixing exchange rate," Economics Letters, Elsevier, vol. 83(1), pages 141-146, April.
    9. Yu‐Lin Wang & Hsiu‐Yun Lee, 2009. "Rules versus discretion on the choice between exchange‐rate‐targeting and monetary‐aggregate‐targeting," Journal of Economic Policy Reform, Taylor and Francis Journals, vol. 12(1), pages 43-55.
    10. Constantino Hevia & Juan Pablo Nicolini, 2013. "Optimal Devaluations," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 61(1), pages 22-51, April.
    11. Oi, Hiroyuki & Otani, Akira & Shirota, Toyoichiro, 2004. "The Choice of Invoice Currency in International Trade: Implications for the Internationalization of the Yen," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 22(1), pages 27-63, March.
    12. Enrique G. Mendoza, 2005. "Real Exchange Rate Volatility and the Price of Nontradables in Sudden-Stop-Prone Economies," NBER Working Papers 11691, National Bureau of Economic Research, Inc.
    13. Yu-Lin Wang & Hsiu-Yun Lee, 2009. "Rules versus discretion on the choice between exchange-rate-targeting and monetary-aggregate-targeting," Journal of Economic Policy Reform, Taylor & Francis Journals, vol. 12(1), pages 43-55.
    14. Campa, Jose Manuel & Gonzalez Minguez, Jose M., 2006. "Differences in exchange rate pass-through in the euro area," European Economic Review, Elsevier, vol. 50(1), pages 121-145, January.
    15. Duarte, Margarida, 2003. "Why don't macroeconomic quantities respond to exchange rate variability?," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 889-913, May.
    16. Polterovich, Victor & Popov, Vladimir, 2003. "Accumulation of Foreign Exchange Reserves and Long Term Growth," MPRA Paper 20069, University Library of Munich, Germany.
    17. Hoffmann, Mathias & Tillmann, Peter, 2012. "International financial integration and national price levels: The role of the exchange rate regime," Journal of International Money and Finance, Elsevier, vol. 31(6), pages 1503-1528.
    18. Velasco, Andrés, 2005. "Editor's summary," LSE Research Online Documents on Economics 123142, London School of Economics and Political Science, LSE Library.
    19. Mihailov, Alexander, 2003. "Effects of the Exchange-Rate Regime on Trade under Monetary Uncertainty: The Role of Price Setting," Economics Discussion Papers 8865, University of Essex, Department of Economics.
    20. Donayre, Luiggi & Panovska, Irina, 2016. "State-dependent exchange rate pass-through behavior," Journal of International Money and Finance, Elsevier, vol. 64(C), pages 170-195.
    21. Tille, Cedric, 2005. "The welfare effect of international asset market integration under nominal rigidities," Journal of International Economics, Elsevier, vol. 65(1), pages 221-247, January.
    22. Alexander Mihailov, 2004. "Effects of the exchange-rate regime on trade: the role of price setting," Money Macro and Finance (MMF) Research Group Conference 2003 66, Money Macro and Finance Research Group.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Michael B. Devereux & Charles Engel, 2001. "The Optimal Choice of Exchange Rate Regime: Price-Setting Rules and Internationalized Production," NBER Chapters, in: Topics in Empirical International Economics: A Festschrift in Honor of Robert E. Lipsey, pages 163-194, National Bureau of Economic Research, Inc.
    2. Michael B. Devereux & Charles Engel, 1998. "Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime," NBER Working Papers 6867, National Bureau of Economic Research, Inc.
    3. Lane, Philip R., 2001. "The new open economy macroeconomics: a survey," Journal of International Economics, Elsevier, vol. 54(2), pages 235-266, August.
    4. Michael B. Devereux & Charles Engel, 2003. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 70(4), pages 765-783.
    5. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "New directions for stochastic open economy models," Journal of International Economics, Elsevier, vol. 50(1), pages 117-153, February.
    6. Engel, Charles & Devereux, Michael B, 2000. "Monetary Policy In The Open Economy Revisited: Price Setting Rules And Exchange Rate Flexibility," CEPR Discussion Papers 2454, C.E.P.R. Discussion Papers.
    7. B. Gabriela Mundaca & Jon Strand, 2005. "A risk allocation approach to optimal exchange rate policy," Oxford Economic Papers, Oxford University Press, vol. 57(3), pages 398-421, July.
    8. Maurice Obstfeld, 2001. "International Macroeconomics: Beyond the Mundell-Fleming Model," NBER Working Papers 8369, National Bureau of Economic Research, Inc.
    9. Charles Engel, 2002. "The Responsiveness of Consumer Prices to Exchange Rates And the Implications for Exchange-Rate Policy: A Survey Of a Few Recent New Open-Economy..," NBER Working Papers 8725, National Bureau of Economic Research, Inc.
    10. Philippe Bacchetta & Eric van Wincoop, 1998. "Does Exchange Rate Stability Increase Trade and Capital Flows?," Working Papers 98.04, Swiss National Bank, Study Center Gerzensee.
    11. Charles Engel, 2003. "Expenditure Switching and Exchange-Rate Policy," NBER Chapters, in: NBER Macroeconomics Annual 2002, Volume 17, pages 231-300, National Bureau of Economic Research, Inc.
    12. Corsetti, Giancarlo & Dedola, Luca, 2002. "Macroeconomics of international price discrimination," Working Paper Series 176, European Central Bank.
    13. Sutherland, Alan, 2005. "Incomplete pass-through and the welfare effects of exchange rate variability," Journal of International Economics, Elsevier, vol. 65(2), pages 375-399, March.
    14. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare and Macroeconomic Interdependence," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 116(2), pages 421-445.
    15. Mihailov, Alexander, 2003. "When and How Much Does a Peg Increase Trade? The Role of Trade Costs and Import Demand Elasticity under Monetary Uncertainty," Economics Discussion Papers 8866, University of Essex, Department of Economics.
    16. Alpaslan AKÇORAOĞLU, 2012. "Yeni Açık Ekonomi Makroiktisat Teorisi ve Para Politikasının Uluslararası Boyutları," Ekonomik Yaklasim, Ekonomik Yaklasim Association, vol. 23(85), pages 57-82.
    17. Alexander Mihailov, 2004. "Effects of the exchange-rate regime on trade: the role of price setting," Money Macro and Finance (MMF) Research Group Conference 2003 66, Money Macro and Finance Research Group.
    18. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Chapters, in: NBER Macroeconomics Annual 2000, Volume 15, pages 339-412, National Bureau of Economic Research, Inc.
    19. Mihailov, Alexander, 2003. "Effects of the Exchange-Rate Regime on Trade under Monetary Uncertainty: The Role of Price Setting," Economics Discussion Papers 8865, University of Essex, Department of Economics.
    20. David Bowman & Brian M. Doyle, 2003. "New Keynesian, open-economy models and their implications for monetary policy," International Finance Discussion Papers 762, Board of Governors of the Federal Reserve System (U.S.).

    More about this item

    JEL classification:

    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:7889. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: the person in charge (email available below). General contact details of provider: https://edirc.repec.org/data/nberrus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.