Optimal exchange rate policy: The influence of price setting and asset markets

This paper examines optimal exchange rate policy in two-country sticky-price general equilibrium models in which households and farms optimize over an infinite horizon in an environment of uncertainty. The models are in the vein of the "new open-economy macroeconomics" as exemplified by Obstfeld and Rogoff (1995, 1998, 2000). The conditions under which fixed or floating exchange rates yield higher welfare depend on the exact nature of price stickiness and on the degree of risk-sharing opportunities. This paper presents some preliminary empirical evidence on the behavior of consumer prices in Mexico that suggests failures of the law of one price are important. The evidence on price setting and risk-sharing opportunities is not refined enough to make definitive conclusions about the optimal exchange rate regime for that country.