This paper investigates the role of money illusion on exchange rate dynamics in a small open economy. We find that whether the exchange rate overshoots in response to a monetary shock is not depend on the parameters such as the consumption elasticity of money demand and the degree of openness proposed by Lane (1997), but the phenomenon of money illusion, this is because the degree of correlation between money demand and consumption is lower with the existence of money illusion, hence the exchange rate must present the excessive adjustment in order to re-achieve the new equilibrium position of the money market, exchange rate overshooting takes place.

In this paper, New Open Economy Macroeconomics is served as an analytical framework to build Contribution/ OriginalityThis study contributes to the existing literature by providing a detailed account of how tariff change on macroeconomic variables in an open economy. We found that if the asymmetric consumption bias behavior exists, the dynamic adjustment process of tariff shock on macroeconomic variables will present phenomenon of undershooting, overshooting or mis-adjustment.

This paper develops a model with imperfect competition and micro-foundation based on the framework of New Open Economy Macroeconomics in order to discuss government spending shock on macroeconomic fluctuations (for example, consumption, output, price, and terms of trade, etc.) under the fixed exchange rate regime and try to explain the role of consumption home bias. By way of theoretical derivation and simulation analysis, this paper discovers that without consideration of consumption home bias under the fixed exchange rate regime in the long term, government spending is positively related to domestic output but is negatively related to private sector consumption, price and terms of trade. Once you take consumption home bias into consideration like that consumers in two countries both are in favor of home goods, the relationship among government spending, consumption, output, and price will be reversed. And, in the short term government spending only will have an influence on interest rate and both of them are positive correlative. Contribution/ Originality:This study provides a detailed account of how government spending shock on macroeconomic fluctuations under the fixed exchange rate regime. We found that the role of consumption home bias affects the effects of government spending shock on macroeconomics variables in the long and short term.

This paper extends the model setup of Devereux and Engel (1998) to investigate how consumption home bias, capital mobility, and price-setting behavior affect the consumption volatility, expected level of consumption, and the welfare performance under alternative exchange rate regimes for a country facing foreign monetary shock. The paper then discusses the issue of the choice of exchange rate regime. According to the analysis of theoretical derivation and simulation, the following conclusions are made. First, the variance of domestic consumption is lowest under a floating exchange rate with pricing-to-market (PTM model for short), and the variance of consumption under floating exchange rate with producer-currency pricing (the PCP model for short) depends on the degree of capital mobility, the share of tradable goods, and the degree of home bias. Secondly, the fixed exchange rate (FER) will dominate the floating exchange rate in terms of the expected level of consumption. Thirdly, from the perspective of welfare performance, a floating exchange rate with pricing-to-market (PTM model) is preferable to a fixed exchange rate. A fixed exchange rate dominates a floating exchange rate with producer-currency pricing (PCP model), and the lower degree of capital mobility induces a higher welfare under fixed exchange rate but a lower welfare under PTM and PCP models.KEY WORDS: home bias, capital mobility, price-setting behavior, exchange rate regime, NOEM JEL CLASSIFICATIONS: F33, F41, F55

This paper investigates the effects of fiscal expenditure shock on exchange rate behavior and the role of asymmetric pricing-to-market in the New Open Economy Macroeconomics. The findings of this paper indicated that if discriminatory pricing behavior is considered, and when a country faced with a fiscal expenditure shock, exchange rate fluctuation in the short run would be wider than in the long run with overshooting of exchange rate. Further, the increase of government expenditure will push up exchange rates. If the firms in both countries take pricing based on home (foreign) currency, an enlargement of the size of the home country will cause lesser (wider) range of exchange rate fluctuation with the change in government expenditure. In addition, the greater the effect of the elasticity of substitution among the products and marginal utility of the real money demand will trigger lesser range of exchange rate fluctuation with the change in government expenditure.