Financial integration, nominal rigidity, and monetary policy

This paper shows that financial integration may reduce welfare in the presence of nominal price rigidity. From a policy perspective, the model implies that developing countries that are experiencing financial integration may attempt to alleviate the welfare cost of integration by stabilizing the exchange rate. Hence, this paper provides a novel explanation for “fear of floating”. For industrial countries that have the ability to operate efficient inflation targeting policy, financial integration is always beneficial. Thus, the different monetary regimes implemented in the industrial vs. the developing countries explain their divergent degrees of financial integration since the early 1990s.