Expectations, Monetary Policy, and the Misalignment of Traded Goods Prices

Nominal exchange rates are asset prices—they are the relative price of two moneys—and are determined largely by expected future macroeconomic conditions. When some goods prices are sticky in each currency, exchange rate changes also determine changes in the relative prices of goods. There is a sticky-price distortion, since freely set relative goods prices do not in general act like the relative price of two moneys. Large nominal exchange rate swings, reflecting expectations of the future, can lead to substantial misalignments in prices, even flexible commodity prices, when some nominal prices are sticky. This misalignment will occur even when foreign exchange is priced “rationally”—with no bubbles. In a series of stylized models, we examine the implications for monetary policy.