Monetary Policy and the Adjustment to Country-Specific Shocks

Empirical evidence documents a low pass-through of exchange rate changes to consumer prices in the short-run under a flexible exchange rate regime and the existence of relative price differentials across countries under a fixed exchange rate regime. Whether a two-country model is consistent with the relative price observation in addition to the pass-through observation has important implications for the optimal degree of nominal exchange rate variability in response to country-specific shocks.