Can flexible Exchange Rates Insulate the Impact of Foreign Monetary Shocks?

Can flexible Exchange Rates Insulate the Impact of Foreign Monetary Shocks?: The Case of Monopolistic Competition

In a two-country model of monopolistic competition where PPP holds at aggregate price levels, this paper examines whether market imperfections alone can fail flexible exchange rates to insulate aggregate output from foreign monetary shocks. It finds that the possibility of insulation hinges on whether monopolists can freely adjust their individual prices to optimum If monopolists keep rigid their individual prices, these shocks will destabilize domestic aggregate output; and the greater the degree of monopoly power, the larger the output fluctuations. The study conveys an implication for recent menu-costs models that price adjustment costs not only can cause price stickiness and non-neutrality of money, as they have shown but can fail flexible rate to achieve insulation as well.