International Risk-Sharing and the Exchange Rate : Re-Evaluating the Case for Flexible Exchange Rates

A classic argument for flexible exchange rates is that the exchange rate plays a 'shock-absorber' role in an open economy vulnerable to country-specific shocks. This paper presents a sharp counter-example to this argument within a very conventional open economy model. Countries are subject to unpredictable shocks to world demand for their goods. Efficient adjustment is prevented, both by sticky nominal wages and by the absence of a market for hedging consumption risk internationally. A flexible exchange rate policy acts perfectly as a 'shock-absorber', fully stabilizing output and replicating the flexible wage outcome. Despite this, a policy that fixes the exchange rate may be welfare superior, even though fixed exchange rates cause output to deviate from the flexible wage outcome. Moreover, an optimal monetary rule in this environment would always dampen exchange rate movements, and may even be a fixed exchange rate