Exchange Rate Policy and Endogenous Price Flexibility

Most theoretical analysis of flexible vs. fixed exchange rates take the degree of nominal rigidity to be independent of the exchange rate regime choice itself. But informal policy discussion often suggests that a credible exchange rate peg may increase internal price flexibility. This paper explores the relationship between exchange rate policy and price flexibility, in a model where price flexibility is an endogenous choice of profit-maximizing firms. A fixed exchange rate may increase the optimal degree of price flexibility by increasing the volatility of demand facing firms. We find that a unilateral peg, such as a Currency Board, adopted by a single country, will increase internal price flexibility, perhaps by a large amount. On the other hand, when an exchange rate peg is supported by bilateral participation of all monetary authorities (such as a monetary union), price flexibility is likely to be little affected, and may actually be less than under freely floating exchange rates.