Real Exchange Rate and Output Variability: The Role of Sticky Prices

The relationships between the degree of price stickiness and the variability of output and the real exchange rate are investigated in an open economy with flexible exchange rates and capital mobility. A critical degree of price inflexibility is shown to exist below which increased inflexibility reduces the variability of output. Also, as prices become more inflexible, the relationship between the variability of the real exchange rate and that of output will be nonmonotonic; that is, as the variability of the real exchange rate increases, the variability of output first declines and then increases.