DP4300 | The Expenditure Switching Effect and the Choice Between Fixed and Floating Exchange Rates

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A two-country sticky-price general equilibrium model is used to examine the implications of the expenditure switching effect for the welfare properties of fixed and floating exchange rate regimes. A comparison between the two regimes shows that the volatility of consumption is unambiguously lower in the floating exchange rate regime, but the volatility of home output can be higher or lower depending on the value of the elasticity of substitution between home and foreign goods. A utility-based welfare comparison of the two regimes concludes that a floating exchange rate regime yields higher welfare when the expenditure switching effect is relatively weak, but a fixed exchange rate regime is superior when the expenditure switching effect is strong.