Monetary policy in the open economy revisited: The case for exchange-rate flexibility restored

This paper revisits the sticky-price pricing-to-market model of Devereux and Engel [Devereux, M.B., Engel, C., 2003. Monetary policy in the open economy revisited: price setting and exchange-rate flexibility. Review of Economic Studies 70(4), 765–783], in which fixed exchange rates are optimal even in the face of country-specific nonmonetary shocks. We show that this result hinges critically on the Devereux–Engel model's prediction that international consumption levels are perfectly synchronized under flexible prices. Realistic modifications of the model that produce nonsynchronous consumption movements – such as, the presence of nontraded goods – upset the fixed exchange rate prescription even in the absence of an expenditure-switching role of exchange rate changes.