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Does Exchange Rate Stability Increase Trade and Welfare ?

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  • Philippe BACCHETTA
  • Eric VAN WINCOOP

Abstract

We develop a simple general equilibrium framework to study the effect of the exchange rate system on trade and welfare. An important feature of the model is deviations from purchasing power parity, caused by rigid price setting in buyers' currency. We find the following. First, exchange rate stability is not necessarily associated with more trade.In a simple benchmark model with separable preferences and only monetary shocks, trade is unaffected by the exchange rate system, consistent with most evidence. Second, both trade and welfare can be higher under either exchange rate system, depending on preferences and on the monetary policy rules followed under each system. Finally, in general there is no one-to-one relationship between the levels of trade and welfare across exchange rate systems.

Suggested Citation

  • Philippe BACCHETTA & Eric VAN WINCOOP, 1999. "Does Exchange Rate Stability Increase Trade and Welfare ?," Cahiers de Recherches Economiques du Département d'économie 9917, Université de Lausanne, Faculté des HEC, Département d’économie.
  • Handle: RePEc:lau:crdeep:9917
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    References listed on IDEAS

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    1. Backus, David K. & Smith, Gregor W., 1993. "Consumption and real exchange rates in dynamic economies with non-traded goods," Journal of International Economics, Elsevier, vol. 35(3-4), pages 297-316, November.
    2. Betts, Caroline & Devereux, Michael B., 1996. "The exchange rate in a model of pricing-to-market," European Economic Review, Elsevier, vol. 40(3-5), pages 1007-1021, April.
    3. Philippe Bacchetta & Eric van Wincoop, 1998. "Does Exchange Rate Stability Increase Trade and Capital Flows?," Working Papers 98.04, Swiss National Bank, Study Center Gerzensee.
    4. Baron, David P, 1976. "Flexible Exchange Rates, Forward Markets, and the Level of Trade," American Economic Review, American Economic Association, vol. 66(3), pages 253-266, June.
    5. Bohn, Henning, 1990. "A positive theory of foreign currency debt," Journal of International Economics, Elsevier, vol. 29(3-4), pages 273-292, November.
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    More about this item

    Keywords

    exchange rate volatility; exchange rate regime;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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