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Rational Fear of Floating: A Simple Model of Exchange Rates and Income Distribution

  • Hans Keiding

    (Institute of Economics, University of Copenhagen)

  • Mette J. Knudsen

    (Institute of Economics, University of Copenhagen)

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    We consider a simple two-country model, where each country produces a consumption good from a single input. Production takes time, and the model is considered over two consecutive periods. There are three categories of economic agents, namely factor owners, entrepreneurs, and financial intermediaries. The latter offers credits to entrepreneurs and are funded by sale internationally transferable bonds. We assume that the national credit markets are monopolistic but that other markets are competitive. Exchange rate policy is introduced in two different ways, either as a market intervention by a government, sustained by intervention in the commodity market, and, more realistically, as a policy commitment by the monetary authorities, which in equilibrium is taken into consideration by the financial intermediary. The results of the simple model show that an increase in the value of the domestic currency from an equilibrium position will in most cases decrease aggregate welfare of the country, but it will improve welfare of the financial intermediaries. Thus, in the simple framework of our model, a specific sector – and one with a considerable influence on policy choices – stands to gain from this exchange rate policy.

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    File URL: http://www.econ.ku.dk/english/research/publications/wp/2005/0503.pdf/
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    Paper provided by University of Copenhagen. Department of Economics in its series Discussion Papers with number 05-03.

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    Length: 14 pages
    Date of creation: Feb 2005
    Handle: RePEc:kud:kuiedp:0503
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    1. von Hagen, Jürgen & Zhou, Jizhong, 2006. "Fear of Floating and Fear of Pegging: An Empirical Analysis of De Facto Exchange Rate Regimes in Developing Countries," CEPR Discussion Papers 5530, C.E.P.R. Discussion Papers.
    2. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
    3. Levy-Yeyati, Eduardo & Sturzenegger, Federico, 2005. "Classifying exchange rate regimes: Deeds vs. words," European Economic Review, Elsevier, vol. 49(6), pages 1603-1635, August.
    4. Francisco Gallego & Geraint Jones, 2006. "Exchange Rate Interventions and Insurance: Is Fear of Floating a Cause for Concern?," Central Banking, Analysis, and Economic Policies Book Series, in: Ricardo Caballero & César Calderón & Luis Felipe Céspedes & Norman Loayza (Series Editor) & Klaus Sc (ed.), External Vulnerability and Preventive Policies, edition 1, volume 10, chapter 11, pages 353-398 Central Bank of Chile.
    5. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, March.
    6. Alberto Alesina & Alexander Wagner, 2003. "Choosing (And Reneging On) Exchange Rate Regimes," Harvard Institute of Economic Research Working Papers 2008, Harvard - Institute of Economic Research.
    7. Sims, Christopher A, 2001. "Fiscal Consequences for Mexico of Adopting the Dollar," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 597-616, May.
    8. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, March.
    9. Honig, Adam, 2005. "Fear of floating and domestic liability dollarization," Emerging Markets Review, Elsevier, vol. 6(3), pages 289-307, September.
    10. Amartya Lahiri & Carlos A. Végh, 2002. "Living with the Fear of Floating: An Optimal Policy Perspective," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 663-704 National Bureau of Economic Research, Inc.
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