Credit market imperfections and nominal exchange rate regimes

Abstract

This paper presents a two‐country, two‐good, two‐currency overlapping generations model that features limited participation and costly state verification in the credit markets. The model is used to study the role of financial factors in the international transmission of business fluctuations, and to analyse whether the presence of credit market imperfections may have an important impact on the relative desirability of alternative exchange rate regimes. In the presence of informational frictions in credit markets, shocks to productivity are shown to have different channels of influence on the world economy under alternative exchange rate regimes. Therefore, real exchange rate variability depends on the nominal exchange rate regime. It is also shown that although a flexible exchange rate regime may insulate a country from the real shocks of other countries, such shocks may lead the country to attain higher expected welfare levels under a fixed exchange rate regime. © 1998 John Wiley & Sons, Ltd.