Rational Fear of Floating: A Simple Model of Exchange Rates and Income Distribution

We consider a simple two-country model, where each country produces a consumption good from a single input. Production takes time, and the model is considered over two consecutive periods. There are three categories of economic agents, namely factor owners, entrepreneurs, and financial intermediaries. The latter offers credits to entrepreneurs and are funded by sale internationally transferable bonds. We assume that the national credit markets are monopolistic but that other markets are competitive. Exchange rate policy is introduced in two different ways, either as a market intervention by a government, sustained by intervention in the commodity market, and, more realistically, as a policy commitment by the monetary authorities, which in equilibrium is taken into consideration by the financial intermediary. The results of the simple model show that an increase in the value of the domestic currency from an equilibrium position will in most cases decrease aggregate welfare of the country, but it will improve welfare of the financial intermediaries. Thus, in the simple framework of our model, a specific sector – and one with a considerable influence on policy choices – stands to gain from this exchange rate policy.