Relative Price Risk in the Open Economy -- The Case of Fixed Exchange Rates

The impact of aggregate nominal and real shocks on the variance of relative prices is studied in the case of an open economy with fixed exchange rates where agents have limited information about aggregate shocks and the price level. In the first part of the paper it is shown that the limited information problem causes an excess variance of relative prices. Increasing the variance of all aggregate shocks lowers the quality of the information conveyed by the domestic price level. The second part of the paper compares fixed and flexible exchange rate regimes under a variance of relative prices criterion. Conditions for the superiority of either regime are identified.