Input Substitution, Export Pricing, and Exchange Rate Policy

This working paper was written by Kang Shi (The Chinese University of Hong Kong) and Juanyi Xu (Hong Kong University of Science and Technology, and Simon Fraser University).This paper develops a small open economy model with sticky prices to show why a flexible exchange rate policy is not desirable in East Asian emerging market economies. We argue that weak input substitution between local labor and import intermediates in traded goods production and extensive use of foreign currency in export pricing in these economies can help to explain this puzzle. In the presence of these two trade features, the adjustment role of the exchange rate is inhibited, so even a flexible exchange rate cannot stabilize the real economy in face of external shocks. Instead, due to the high exchange rate pass-through, exchange rate changes will lead to instability in both inflation and production cost. As a result, a fixed exchange rate may dominate a monetary policy rule with high exchange rate flexibility in terms of welfare. In a sense, our finding provides a rationale for the “fear of floating” phenomenon in these economies. That is, “fear of floating” may be central banks’ rational reaction when these economies are constrained by the trade features mentioned above