Trade Openness, Real Exchange Rates, and the Exchange Rate Regime Choice
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Abstract
Among trading economies, the advantage of exible exchangerates lies in exploiting the ‘expenditure switching eect of de-preciation’ to stabilize their citizens’ consumption in the face ofasymmetric shocks in the short run when nancial markets arenot complete. For short run stabilization, policy makers may wantto increase money supply and depreciates their exchange rate toworsen the terms of trade in favor of home goods’ price compet-itiveness, increasing exports, output, income and consumption.When an economy is too open in terms of trade in goods, however,depreciation itself weakens its ‘expenditure-switching eect’ of de-preciation by raising the imports prices and their citizens’ cost ofliving. In an extreme case where trading economies are completelyintegrated via trade [in the sense that households across tradingeconomies have the same compositions of consumption baskets],depreciation increases their cost of living exactly by the amountthat completely osets the terms of trade worsening by itself sothat the purchasing power parity would always hold. In this case,depreciation would not have the expenditure switching eect andtherefore no real eect of stabilization at all. With complete in-tegration, the performances of xed and exible rates in terms ofshort run consumption smoothing for households with the degreeof relative risk aversion of CRRA utility greater than unity wouldbecome indifferent.
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