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Exchange Rate Regimes and Financial-Market Imperfections

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  • Joshua Aizenman
  • Ricardo Hausmann

Abstract

This paper investigates the design of an exchange rate policy for an economy where the domestic capital market is segmented from the global financial market, producers rely on credit to finance working capital needs, and the labor market is characterized by nominal contracts. We show that the choice of an exchange rate regime is intertwined with the financial structure -- greater reliance on working capital to finance input needs, and greater segmentation of the domestic capital market increase the desirable exchange rate stability. This result follows from the observation that greater exchange rate stability is likely to reduce the real interest rate facing the producer, thereby increasing output. Hence, greater reliance on working capital increases the welfare gain attached to the lower interest rate associated with lower flexibility of the exchange rate, thereby increasing the desirability of a fixed exchange rate. Similarly, greater integration with the global capital market reduces the real interest rate benefits from exchange rate stability, increasing thereby the optimal flexibility of the exchange rate, and reducing the demand for international reserves.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7738.

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Date of creation: Jun 2000
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Handle: RePEc:nbr:nberwo:7738

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  1. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, Elsevier, vol. 2(2), pages 221-235, April.
  2. Obstfeld, Maurice & Rogoff, Kenneth, 1999. "New Directions for Stochastic Open Economy Models," Center for International and Development Economics Research, Working Paper Series, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkele qt5pf7g8sh, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  3. Hausmann, Ricardo & Panizza, Ugo & Stein, Ernesto, 2001. "Why do countries float the way they float?," Journal of Development Economics, Elsevier, Elsevier, vol. 66(2), pages 387-414, December.
  4. Aizenman, Joshua, 1994. "Monetary and Real Shocks, Productive Capacity and Exchange Rate Regimes," Economica, London School of Economics and Political Science, London School of Economics and Political Science, vol. 61(244), pages 407-34, November.
  5. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  6. Aizenman, Joshua & Frenkel, Jacob A, 1985. "Optimal Wage Indexation, Foreign Exchange Intervention, and Monetary Policy," American Economic Review, American Economic Association, American Economic Association, vol. 75(3), pages 402-23, June.
  7. Barro, Robert J., 1977. "Long-term contracting, sticky prices, and monetary policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 3(3), pages 305-316, July.
  8. Ricardo Hausmann & Michael Gavin & Carmen Pag├ęs-Serra & Ernesto H. Stein, 1999. "Financial Turmoil and Choice of Exchange Rate Regime," Research Department Publications, Inter-American Development Bank, Research Department 4170, Inter-American Development Bank, Research Department.
  9. Barry Eichengreen & Ricardo Hausmann, 1999. "Exchange rates and financial fragility," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Kansas City, pages 329-368.
  10. Jeffrey A. Frankel, 1999. "No Single Currency Regime is Right for All Countries or At All Times," NBER Working Papers 7338, National Bureau of Economic Research, Inc.
  11. Michael B. Devereux & Charles Engel, 1998. "Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime," NBER Working Papers 6867, National Bureau of Economic Research, Inc.
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Cited by:
  1. Sylwester, Kevin, 2002. "Can education expenditures reduce income inequality?," Economics of Education Review, Elsevier, Elsevier, vol. 21(1), pages 43-52, February.
  2. Artus P., 2001. "What Exchange - Rate System For Emerging Countries?," European Research Studies Journal, European Research Studies Journal, European Research Studies Journal, vol. 0(1-2), pages 27-60, January -.
  3. Kevin Sylwester, 2003. "Income Inequality And Population Density 1500 Ad: A Connection," Journal of Economic Development, Chung-Ang Unviersity, Department of Economics, Chung-Ang Unviersity, Department of Economics, vol. 28(2), pages 61-82, December.

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