Sticky Exchange Rates and Flexible Prices

Real exchange rate variability tends to be higher under flexible than under fixed exchange rates. The neokeynesian view attributes the higher variability to the combination of volatile nominal exchange rates with sticky prices. The neoclassical approach regards an increased incidence of real shocks as the culprit. We test the crucial assumptions underlying the two models for the interwar period. Prices and exchange rates are found to be equally flexible. We hence reject the neokeynesian sticky price view for our sample period. In contrast, our results are consistent with, while not constituting evidence for, the neoclassical equilibrium approach.

Does the Nominal Exchange Rate Regime Matter?

The effect of the exchange rate regime on inflation and growth is examined. The 30-year data set includes over 100 countries and nine regime types. Pegged regimes are associated with lower inflation than intermediate or flexible regimes. This anti-inflationary benefit reflects lower money supply growth (a discipline effect) and higher money demand growth (a credibility effect). Output growth does not vary significantly across regimes: Countries with pegged regimes invest more and are more open to international trade than those with flexible rates, but they experience lower residual productivity growth. Output and employment are more variable under pegged rates than under flexible rates.