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Michael B. Devereux

28 April 2006
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, as well as the elasticity of substitution between home and foreign goods. 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.
JEL Code
F41 : International Economics→Macroeconomic Aspects of International Trade and Finance→Open Economy Macroeconomics
E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy
International research forum on monetary policy