Academic journal article Economic Inquiry

Financial Frictions and the Choice of Exchange Rate Regimes

Academic journal article Economic Inquiry

Financial Frictions and the Choice of Exchange Rate Regimes

Article excerpt


This article provides a quantitative assessment of the role of financial frictions for the choice of exchange rate regimes in a two-country model. The standard new open economy model neglects the role that financial frictions can play for the international transmission of shocks and for the optimal choice of exchange rate regimes. However, several historical episodes, such as the global financial crises during the Gold Standard regime or the exchange rate crisis during the European Monetary System (EMS), have shown the dangers of a close association between financial instability and pegged exchange rates. In general, pegged exchange rates tend to reduce monetary policy flexibility, and those constraints become even more stringent when the domestic economy faces credit frictions. Nowadays, those issues have acquired policy relevance for the euro area as some accession countries entered a system of managed exchange rates with the euro zone, known as the ERM II Central Bank Agreement: (1) the relinquishing of part of their monetary policy flexibility might be a concern as some of those countries are still characterized by unstable financial markets.

To analyze the above-mentioned issues, I use an artificial two-country economy characterized by imperfect financial integration in the market for international securities and sticky prices in an imperfectly competitive framework. The introduction of sticky prices is particularly helpful for comparing different monetary arrangements. To this economy, otherwise similar to those analyzed in some of the recent open-economy-macro literature, (2) I add borrowing constraints on investment associated with balance sheet effects in both countries. (3) Doing so adds realism to the model and moves a step forward toward integrating the analysis of the domestic and the international transmission mechanisms. I simulate the calibrated economy under monetary and productivity shocks, and I compare three different exchange rate regimes--that is, hard pegs, managed exchange rates, and floating exchange rates. To evaluate the relative performance of the different regimes, I rely on the comparison of volatilities for the main macro variables and on a simple welfare metric.

I first consider shocks originated in the foreign country. In the absence of financial frictions, floating exchange rates deliver good stability properties under both productivity and monetary policy shocks. This result confirms Milton Friedman's (1953) case for flexible exchange rate: he argued that in presence of sticky prices, floating exchange rates deliver better insulation properties from foreign shocks as they allow relative prices to adjust faster. In presence of financial frictions, such insulating property is strengthened further. The intuition runs as follows. Under fixed or managed exchange rates, an external shock with devaluation pressures forces the monetary authority to raise interest rates with a consequent increase in the cost of loans. The presence of borrowing constraints on investment exacerbates the tightening effect. To highlight the impact of borrowing constraints on investment, I compare the dynamic properties of the economy with and without agency costs. Both the absolute value for the volatilities of the main macro variables (output, investment, inflation, consumption, asset prices, and return on capital) and the difference in the same volatilities between the two regimes are higher when credit frictions are introduced into the model. Fixed and managed exchange rate regimes also appear to steepen the typical trade-off between inflation and output volatility. This effect is shown by illustrating the fact that the sacrifice ratio (the output-inflation volatility ratio) raises when moving from floating to fixed exchange rate regimes and that such an increase is higher in presence of credit frictions.

I therefore test the robustness of the results by analyzing the model with financial frictions under domestic shocks and under symmetric

and correlated shocks. …

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