Optimal Exchange-Rate Policy in a Model of Local-Currency Pricing with Vertical Production and Trade

In this paper, we examine optimal exchange-rate flexibility in a model of local-currency pricing with vertical production and trade. Following a large body of empirical evidence, we assume that final-goods prices are sticky, but intermediate-goods prices are flexible. We find that, unlike what is found in the literature, optimal nominal exchange rate is flexible under local-currency pricing. The key element in deriving our conclusion is the difference in expenditure shares between home and foreign households. The conclusion holds even if the degrees of home bias in production are identical between home and foreign final-goods producers, which contrasts with the findings in the literature.