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A Risk-based Theory of Exchange Rate Stabilization

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  • Tarek A. Hassan
  • Thomas M. Mertens
  • Tony Zhang

Abstract

We develop a novel, risk-based theory of the effects of exchange rate stabilization. In our model, the choice of exchange rate regime allows policymakers to make their currency, and by extension, the firms in their country, a safer investment for international investors. Policies that induce a country's currency to appreciate when the marginal utility of international investors is high lower the required rate of return on the country's currency and increase the world-market value of domestic firms. Applying this logic to exchange rate stabilizations, we find a small economy stabilizing its bilateral exchange rate relative to a larger economy can increase domestic capital accumulation, domestic wages, and even its share in world wealth. In the absence of policy coordination, small countries optimally choose to stabilize their exchange rates relative to the currency of the largest economy in the world, which endogenously emerges as the world's “anchor currency.” Larger economies instead optimally choose to oat their exchange rates. The model therefore predicts an equilibrium pattern of exchange rate arrangements that is remarkably similar to the one in the data.

Suggested Citation

  • Tarek A. Hassan & Thomas M. Mertens & Tony Zhang, 2020. "A Risk-based Theory of Exchange Rate Stabilization," Working Paper Series 2016-15, Federal Reserve Bank of San Francisco.
  • Handle: RePEc:fip:fedfwp:2016-15
    DOI: 10.24148/wp2016-15
    Note: Published originally 12/2016 as “Currency Manipulation", FRBSF Working Paper 2016-16.
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    Cited by:

    1. Yang Liu & Mariano Croce & Ivan Shaliastovich & Ric Colacito, 2016. "Volatility Risk Pass-Through," 2016 Meeting Papers 135, Society for Economic Dynamics.
    2. Hassan, Tarek A. & Mertens, Thomas M. & Zhang, Tony, 2016. "Not so disconnected: Exchange rates and the capital stock," Journal of International Economics, Elsevier, vol. 99(S1), pages 43-57.
    3. Lukas Menkhoff & Malte Rieth & Tobias Stohr, 2021. "The Dynamic Impact of FX Interventions on Financial Markets," The Review of Economics and Statistics, MIT Press, vol. 103(5), pages 939-953, December.
    4. Tony Zhang, 2022. "Monetary Policy Spillovers through Invoicing Currencies," Journal of Finance, American Finance Association, vol. 77(1), pages 129-161, February.
    5. Kathryn M. E. Dominguez, 2020. "Revisiting Exchange Rate Rules," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 68(3), pages 693-719, September.
    6. Kathryn M. E. Dominguez, 0. "Revisiting Exchange Rate Rules," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 0, pages 1-27.
    7. Kuersteiner, Guido M. & Phillips, David C. & Villamizar-Villegas, Mauricio, 2018. "Effective sterilized foreign exchange intervention? Evidence from a rule-based policy," Journal of International Economics, Elsevier, vol. 113(C), pages 118-138.
    8. Luna Santos, Francisco, 2021. "Comparing the impact of discretionary and pre-announced central bank interventions," Journal of International Money and Finance, Elsevier, vol. 110(C).
    9. Vania Stavrakeva & Jenny Tang, 2018. "The dollar during the global recession: US monetary policy and the exorbitant duty," Working Papers 18-10, Federal Reserve Bank of Boston.
    10. Matteo Maggiori, 2021. "FX policy when financial markets are imperfect," BIS Working Papers 942, Bank for International Settlements.

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    More about this item

    Keywords

    managed float; exchange rate stabilization; uncovered interest parity; currency returns; fixed exchange rates;
    All these keywords.

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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