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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. Robert J. Barro & David B. Gordon, 1983. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
  2. Ricardo Hausmann & Ugo Panizza & Ernesto H. Stein, 2000. "Why Do Countries Float the Way They Float?," Research Department Publications 4205, Inter-American Development Bank, Research Department.
  3. Obstfeld, Maurice & Rogoff, Kenneth, 1999. "New Directions for Stochastic Open Economy Models," Center for International and Development Economics Research, Working Paper Series qt5pf7g8sh, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  4. Aizenman, Joshua & Frenkel, Jacob A, 1985. "Optimal Wage Indexation, Foreign Exchange Intervention, and Monetary Policy," American Economic Review, American Economic Association, vol. 75(3), pages 402-23, June.
  5. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
  6. Barry Eichengreen & Ricardo Hausmann, 1999. "Exchange rates and financial fragility," Proceedings, Federal Reserve Bank of Kansas City, pages 329-368.
  7. 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.
  8. Barro, Robert J., 1977. "Long-term contracting, sticky prices, and monetary policy," Journal of Monetary Economics, Elsevier, vol. 3(3), pages 305-316, July.
  9. 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.
  10. Aizenman, Joshua, 1994. "Monetary and Real Shocks, Productive Capacity and Exchange Rate Regimes," Economica, London School of Economics and Political Science, vol. 61(244), pages 407-34, November.
  11. Ricardo Hausmann & Michael Gavin & Carmen Pagés-Serra & Ernesto H. Stein, 1999. "Financial Turmoil and Choice of Exchange Rate Regime," Research Department Publications 4170, Inter-American Development Bank, Research Department.
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