International financial integration, credit frictions and exchange rate regimes

This paper studies the stabilisation properties of different exchange rate policies in a small open economy with cross-border balance sheet interdependence. The model features price and wage rigidities, credit frictions à la Bernanke, Gertler and Gilchrist (1999) both between households and banks and between banks and entrepreneurs, as well as international financial linkages à la Ueda (2012). I find that, overall, the argument in favor of ?flexible exchange rates holds irrespectively of the degree of financial integration. In fact, for all shocks considered, a fixed exchange rate policy delivers larger output losses and higher volatility of real and financial variables. Furthermore, my results reveal that the cost of pegging the exchange rate is inversely related to the degree of financial integration. Finally, I find that the presence of financial linkages increases the trade-off between inflation and output volatility faced by the central bank of a small open economy.