DP3431 | Incomplete Pass-Through and the Welfare Effects of Exchange Rate Variability

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20/06/2002

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Abstract

This Paper considers the implications of incomplete exchange rate pass-through for optimal monetary and exchange rate policy. A two-country model is presented which allows an explicit derivation of welfare functions in terms of a weighted sum of the second moments of producer prices and the nominal exchange rate. From a single country perspective the optimal exchange rate variance depends on the degree of pass-through, the size and openness of the economy, the elasticity of labour supply and the volatility of foreign producer prices. The optimal coordinated equilibrium can be supported by requiring national central banks to minimize loss functions, which are a weighted sum of the variances of producer prices and the exchange rate, where the weight on the exchange rate variance depends on the degree of pass-through.