It is well known that monetary policy can stabilize the effects of exogenous shocks in a closed economy facing nominal frictions. This task, however, becomes more complex when considering the case of an open economy. The consumption bundle contains imported goods, which makes the extent to which nominal exchange rate fluctuations are passed through to prices important for stabilization policy. The two most widely studied scenarios for exchange rate pass-through are Producer Currency Pricing (PCP) and Local Currency Pricing (LCP). Under PCP a firm sets prices for the export market in domestic currency, while under LCP it sets them in the foreign currency. This article follows Sutherland (2005) and Corsetti and Pesenti (2005) in allowing for a general elasticity of exchange rate pass-through, including PCP and LCP as special cases. This generalization is desirable for several reasons. On a theoretical level, it has been shown that the degree of pass-through plays a crucial role in determining the optimal exchange rate policy. (1) PCP also implies that the Law of One Price holds at all times, which is counterfactual. On an empirical level, recent work has presented evidence that pass-through is partial. (2)
Stabilization in the present framework refers to efforts by the policymaker to reach the allocation that would be obtained in the absence of any nominal rigidities, which serves as a benchmark. The open economy stabilization problem involves taking into account prices of traded goods as well as policy choices by the other country. Because the number of stabilization targets exceeds the number of instruments, basic intuition suggests that adding fiscal stabilization instruments will improve matters. In fact, recent work by Adao, Correia, and Teles (2009) shows that a sufficient number of fiscal instruments in a two-country model will always allow a replication of the flex-price allocation regardless of the exchange rate regime.
This article examines the effects of adding a fiscal stabilization instrument in the form of a labor tax to a two-country framework. The analysis sheds light on some aspects the aforementioned basic intuition may be overlooking. Strategic interaction between the two countries combined with a general degree of exchange rate pass-through make the welfare effect of an additional stabilization instrument non-trivial. The degree of pass-through of the exchange rate turns out to determine (1) whether the additional fiscal instrument is employed at all and (2) whether its availability makes the two countries worse or better off relative to the case where only monetary stabilization is available.
For low degrees of pass-through (including the special case of LCP), both countries are worse-off with the additional instrument relative to a scenario with only monetary stabilization policy. The reason for lower welfare (or destabilization) with the additional instrument is the incentive to manipulate the tax rate in order to affect welfare via the labor supply. At the Nash equilibrium, each country uses its fiscal instrument to stabilize the expected marginal costs facing exporters, which enter welfare through the labor supply. The degree of pass-through determines how much these cost terms fluctuate due to expected exchange rate fluctuations. To see this, consider first the case of LCP. Exporting firms set prices in the foreign currency, which means that exchange rate fluctuations are crucial when forming expectations over next period's marginal costs in terms of domestic currency. At the other extreme, consider PCP. Now, firms set export prices in their own currency, resulting in the absence of the exchange rate from expected costs. Fiscal stabilization sets the change in the labor tax rate to counteract these exchange rate fluctuations, but at the cost of making the tax rate itself variable. With low degrees of pass-through, the fiscal policy rule results in highly volatile tax rates, with destabilizing effect overall. …