Exchange Rates, Local Currency Pricing and International Tax Policies

2021-06-06 Publications

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Empirical evidence suggests that for many countries, retail prices of traded goods are sticky in national currencies. Movements in exchange rates then cause deviations from the law of one price, and exchange rate misalignment, which cannot be corrected by monetary policy alone. This paper shows that a state contingent international tax policy can be combined with monetary policy to eliminate exchange rate misalignment and sustain a fully efficient welfare outcome. But this monetary-fiscal mix cannot be decentralized with non-cooperative determination of monetary and fiscal policy. Non-cooperative use of taxes and subsidies introduces strategic spillovers which opens up a fundamental conflict between the goals of output gap and inflation stabilization and those of terms of trade manipulation in an open economy. The implementation of an efficient monetary-fiscal mix requires effective cooperation in fiscal policy, while leaving monetary policy to be determined non-cooperatively. In addition, while an efficient outcome requires state contingent taxes and subsidies to eliminate exchange rate misalignment, it is still necessary to have flexible exchange rates and independent monetary policy.

Juanyi Xu
Associate Professor, Department of Economics
Professor Juanyi Jenny Xu joined HKUST Department of Economics in 2006. She worked in Simon Fraser…
Sihao Chen
Fudan University
Michael B. Devereux
University of British Columbia
Kang Shi
The Chinese University of Hong Kong

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