DP4300 The Expenditure Switching Effect and the Choice Between Fixed and Floating Exchange Rates

Author(s): Ozge Senay , Alan Sutherland

Publication Date: March 2004

Keyword(s): exchange rates , expenditure switching , welfare

JEL(s): E52 , F41 , F42

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4300.asp

A two-country sticky-price general equilibrium model is used to examine the implications of the expenditure switching effect for the welfare properties of fixed and floating exchange rate regimes. A comparison between the two regimes shows that the volatility of consumption is unambiguously lower in the floating exchange rate regime, but the volatility of home output can be higher or lower depending on the value of the elasticity of substitution between home and foreign goods. A utility-based welfare comparison of the two regimes concludes that a floating exchange rate regime yields higher welfare when the expenditure switching effect is relatively weak, but a fixed exchange rate regime is superior when the expenditure switching effect is strong.