Macroeconomic effects of nominal exchange rate regimes: new insights into the role of price dynamics

This paper analyzes the effects of pegged and floating exchange rates using a two-country dynamic general equilibrium model that is calibrated to the US and a European aggregate. The model assumes shocks to money, productivity and the interest rate parity condition. It captures the fact that the sharp increase in nominal exchange rate volatility after the end of the Bretton Woods (BW) system was accompanied by a commensurate rise in real exchange rate volatility, but had no pronounced effect on the volatility of GDP. This holds irrespective of whether flexible or sticky prices are assumed-which casts doubt on the widespread view that the roughly equal (post-BW) rise in nominal and real exchange rate volatility reflects price stickiness. A flex-prices variant of the model captures better the fact that the correlation between US and European GDP has been higher in the post-BW era than under BW.