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An analysis of the welfare implications of alternative exchange rate regimes: an intertemporal model with an application

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  • Andrew Feltenstein
  • David E. Lebow
  • Anne C. Sibert

Abstract

We construct a two-period model of an open economy and use the model to analyze the welfare implications of fixed and floating exchange regimes. Consumers have perfect foresight and save by holding domestic and foreign bonds, which are chosen according to relative interest rates, deflated by the rate of devaluation of the domestic currency. The government produces a pure public good and finances its deficits by issuing money, domestic bonds, and by foreign borrowing. The government's bonds compete with private investment, which is entirely debt financed. Foreign exchange, i.e., foreign bonds, is made available via the current account, endogenous private borrowing, and exogenous public borrowing. The government, in turn, acts as a passive auctioneer, trading foreign currency at market prices, and the exchange rate is defined as the domestic price of foreign bonds. ; The parameters of the model are estimated for Australia, and two counterfactual simulations have been carried out. In the first of these, a fixed exchange regime has been imposed upon 1983-84, when the exchange rate was actually allowed to float. Assuming that all exogenous parameters remain constant, the welfare implications of the two regimes are compared. The floating regime is found to be welfare superior for both categories of domestic consumers. Similar results are derived in a simulation in which the floating regime is imposed upon 1981-82, when a fixed exchange regime was actually in place. Our initial conclusion would be that, from the point of view of consumer welfare, floating exchange rates are superior to fixed rates in this Australian case.

Suggested Citation

  • Andrew Feltenstein & David E. Lebow & Anne C. Sibert, 1986. "An analysis of the welfare implications of alternative exchange rate regimes: an intertemporal model with an application," International Finance Discussion Papers 273, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:273
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    References listed on IDEAS

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    1. Blanchard, Olivier J, 1985. "Debt, Deficits, and Finite Horizons," Journal of Political Economy, University of Chicago Press, vol. 93(2), pages 223-247, April.
    2. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    3. Cushman, David O., 1983. "The effects of real exchange rate risk on international trade," Journal of International Economics, Elsevier, vol. 15(1-2), pages 45-63, August.
    4. Frenkel, Jacob A. & Aizenman, Joshua, 1982. "Aspects of the optimal management of exchange rates," Journal of International Economics, Elsevier, vol. 13(3-4), pages 231-256, November.
    5. Dornbusch, Rudiger, 1973. "Currency Depreciation, Hoarding, and Relative Prices," Journal of Political Economy, University of Chicago Press, vol. 81(4), pages 893-915, July-Aug..
    6. Enders, Walter & Lapan, Harvey E., 1979. "Stability, Random Disturbances, and the Exchange Rate Regime," ISU General Staff Papers 197907010700001067, Iowa State University, Department of Economics.
    7. Kenneth S. Chan, 1982. "Rational Expectations and the Optimal Foreign Exchange Regimes," Canadian Journal of Economics, Canadian Economics Association, vol. 15(1), pages 164-174, February.
    8. Shoven, John B & Whalley, John, 1984. "Applied General-Equilibrium Models of Taxation and International Trade: An Introduction and Survey," Journal of Economic Literature, American Economic Association, vol. 22(3), pages 1007-1051, September.
    9. Helpman, Elhanan, 1981. "An Exploration in the Theory of Exchange-Rate Regimes," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 865-890, October.
    10. Bewley, R A, 1982. "On the Functional Form of Engel Curves: The Australian Household Expenditure Survey, 1975-76," The Economic Record, The Economic Society of Australia, vol. 58(160), pages 82-91, March.
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    Cited by:

    1. Feltenstein, Andrew & Shah, Anwar, 1995. "General equilibrium effects of investment incentives in Mexico," Journal of Development Economics, Elsevier, vol. 46(2), pages 253-269, April.
    2. Plassmann, Florenz & Feltenstein, Andrew, 2016. "How large do multi-region models need to be?," Journal of Policy Modeling, Elsevier, vol. 38(1), pages 138-155.

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    Keywords

    Foreign exchange rates ; Australia;

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