Foreign Financial Deregulation under Flexible and Fixed Exchange Rates

An enhanced Mundell-Fleming model with domestic and foreign banking deregulation is considered for a small open economy. Deregulation is assumed to influence net capital outflows. It can be shown that under fixed exchange rates, foreign deregulation reduces output and employment and therefore there will be an international resistance to strong deregulation abroad - typically in the US or the UK whose big banking sectors could give an inherent incentive to deregulate. Under flexible exchange rates, banking deregulation abroad raises output and employment so that banking deregulation in the US - or the UK - will face less resistance than under a system of fixed exchange rates; excessive deregulation pressure could emerge in a system of flexible rates. There is a new trilemma. While banking deregulation might bring a national and global output increase in the medium term, the long-run effects could be higher government restructurings cost related to ailing banks in OECD countries. The debate of fixed exchange rates versus flexible exchange rates thus has a new additional aspect, namely the probability of banking deregulation. A key policy implication derived is thus that in a system of flexible exchange rates national and international as well as IMF monitoring of banking regulation quality is important for economic stability and welfare - the IMF's FSAP and the work of the BIS are quite crucial. BREXIT allows one to expect a wave of deregulation in the UK (plus US); with negative external effects worldwide. New long-run effects are also considered in an enhanced Solow growth model with risk, trade and FDI.