The Responsiveness of Consumer Prices to Exchange Rates and the Implications for Exchange-Rate Policy: A Survey of a Few Recent New Open-Economy..

37 Pages Posted: 17 Jan 2002 Last revised: 5 Nov 2022

See all articles by Charles M. Engel

Charles M. Engel

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics

Date Written: January 2002

Abstract

The traditional case for flexibility in nominal exchange rates assumes that there is nominal price stickiness that prevents relative prices from adjusting in response to real shocks. When prices are sticky in producers' currencies, nominal exchange rate changes can achieve the relative price change that is required between home and foreign goods. The nominal exchange rate flexibility provides the desired 'expenditure-switching' effect of relative price changes. But if prices are fixed ex ante in consumers' currencies, nominal exchange rate flexibility cannot achieve any relative price adjustment. In fact, nominal exchange rate fluctuations are undesirable because they lead to deviations from the law of one price. So, fixed exchange rates are optimal. The empirical literature appears to support the notion that prices are sticky in consumers' currencies. This paper surveys the approaches taken in the new open economy macroeconomic literature to formalize the role of optimal monetary policy. The survey explores how this literature has dealt with the empirical evidence on pass-through of exchange rate changes to consumer prices.

Suggested Citation

Engel, Charles M., The Responsiveness of Consumer Prices to Exchange Rates and the Implications for Exchange-Rate Policy: A Survey of a Few Recent New Open-Economy.. (January 2002). NBER Working Paper No. w8725, Available at SSRN: https://ssrn.com/abstract=297351

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