Exchange Rate Regimes and National Price Levels ∗

This paper explores the role of exchange rate regimes in explaining deviations from the classic theory of purchasing power parity. Examining a broad panel of countries, I find that developing countries with fixed exchange rate regimes have significantly higher national price levels than those with flexible regimes. For industrial countries, the association between regimes and price levels is qualitatively similar but weaker. I investigate several explanations for this pattern, and argue that it can be explained as the outcome of a class of open economy macroeconomic models pioneered by Obstfeld and Rogoff. A calibrated version of the benchmark model can account for roughly half of the observed differences. JEL Classification: E52, F33, and F41 ∗I would especially like to thank my advisors Rudi Dornbusch and Jaume Ventura. I would also like to thank Amartya Lahiri, Roberto Benelli, Guido Lorenzoni, Lucas Llach, Paolo Pesenti, Ken Rogoff, John Romalis, Cedric Tille and Kei-Mu Yi for their helpful comments and discussions. I also benefitted from the comments of seminar participants at MIT, New York University, Federal Reserve Bank of New York, Pompeu Fabra, Universidad Torcuato Di Tella, International Monetary Fund, Universidad San Andres, and LACEA 2001. Rachel Polimeni provided excellent research assistance. E-mail: [email protected] The views expressed in this paper do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.