Words of Wisdom:

"We all marvel at the beauty of the Butterfly, but rarely take into account the changes it has undergone to get there." - Axotlyorill

Openness and the case for flexible exchange rates

  • Date Submitted: 06/18/2012 06:17 AM
  • Flesch-Kincaid Score: 53.5 
  • Words: 11594
  • Essay Grade: no grades
  • Report this Essay
Research in Economics 60 (2006) 1–21 www.elsevier.com/locate/rie

Openness and the case for flexible exchange rates*
Giancarlo Corsetti *
European University Institute, University of Rome III and CEPR, Robert Schuman Centre of Advanced Studies, Convento, Via delle Fontanelle 19, I-50016 San Domenico di Fiesole (FI), Italy Received 9 December 2005; accepted 2 February 2006

Abstract Models of stabilization in open economy traditionally emphasize the role of exchange rates as a substitute for nominal price flexibility in fostering relative price adjustment. This view has been recently criticized on the ground that, to the extent that prices are sticky in local currency, the exchange rate does not play the stabilizing role envisioned by the received wisdom. An important question is whether, for this very reason, stabilization policies should limit exchange rate movements, or even eliminate them altogether. In this paper, I re-assess this issue by extending the [Corsetti Giancarlo, and Paolo Pesenti. 2001. Welfare and Macroeconomic Interdependence. Quarterly Journal of Economics 116 (2), 421–446.] model to allow for home bias in consumption—so that I can exploit the advantages of closed-form solutions. While this extension leaves most properties of the model unaffected, home bias implies that the real exchange rate in an efficient equilibrium is not constant, but fluctuates with the terms of trade. The weight that monetary authorities optimally place on stabilizing domestic marginal costs is increasing in home bias: with asymmetric shocks, fixed exchange rates are incompatible with efficient monetary rules. Yet, the adverse welfare consequences of exchange rate movements constrain the optimal intensity of monetary responses to domestic shocks. Openness matters: in our specification each country produces an equal share of the world value added; the lower the import content of consumption, the higher the exchange rate volatility implied by optimal stabilization rules. In...

Comments

Express your owns thoughts and ideas on this essay by writing a grade and/or critique.

  1. No comments