Macroeconomic Effects of Nominal Exchange Rate Regimes: New Insights into the Role of Price Dynamics

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Abstract
This paper analyzes the effects of pegged and floating exchange rates using a two-country dynamic general equilibrium model that is calibrated to the U.S. and a European aggregate. The model assumes shocks to money, productivity and the interest parity condition. It captures the fact that the sharp increase in nominal exchange rate volatility after the abandonment 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 U.S. and European output. This holds irrespective of whether flexible and sticky prices are assumed - which casts doubt on the widespread view that the roughly equal rise in nominal and real exchange rate volatility reflects price stickiness. Flex-prices variants of the model capture better the fact that the cross-region output correlation has been higher in the floating-rate era.

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