Segmented Asset Markets and Optimal Exchange Rate Regimes

Abstract

This paper revisits the issue of the optimal exchange rate regime in a flexible price environment.The key innovation is that we analyze this question in the context of environments where only a fraction of agents participate in asset market transactions (i.e., asset markets are segmented).We show that flexible exchange rates are optimal under monetary shocks and fixed exchange rates are optimal under real shocks. These findings are the exact opposite of the standard Mundellian prescription derived under the sticky price paradigm wherein fixed exchange rates are optimal if monetary shocks dominate while flexible rates are optimal if shocks are mostly real. Our results thus suggest that the optimal exchange rate regime should depend not only on the type of shock (monetary versus real) but also on the type of friction (goods market friction versus financial market friction).

The Risk Premium, Interest Rate Determination, and Monetary Independence Under a Fixed, but Adjustable, Exchange Rate

“…While many researchers regard increasing relative risk aversion as less plausible, the quadratic utility specification was adopted for analytical convenience. Quadratic utility has a long history in finance and macroeconomics and is widely utilized in general-equilibrium frameworks (for example, Stockman, 1978;Flood, 1988;Bergin, 2000;Lahiri, Singh, and Vegh, 2007). 27 Moreover, some economists regard increasing relative risk aversion as an acceptable formulation.…”

How Strong is the Case for Dollarization in Central America? An Empirical Analysis of Business Cycles, Credit Market Imperfections and the Exchange Rate

“…Gelos and Werner (2002) analyze a firm-level data set on Mexican manufacturing establishments and show that especially the smallest firms are financially constrained. A model that takes account of these credit market imperfections in the context of exchange rate regime choice has been developed by Lahiri et al (2007). 24 In our paper, we focus on stabilization policy.…”

Financial Frictions and the Choice of Exchange Rate Regimes

“…7 This article is also related to a strand of the literature that studies the role of other types of financial frictions for the choice of exchange rate regimes. In particular, Lahiri, Singh, and Vegh (2007) challenge 4. See Bernanke, Gertler, and Gilchrist (1999), Carlstrom and Fuerst (1997), and Kiyotaki and Moore (1997).…”

“…the standard Mundell-Fleming prescription by showing that in presence of segmented asset markets, floating exchange rate regimes perform better than fixed exchange rates when shocks are real and vice versa when shocks originate in the money market. Differently than Lahiri, Singh, and Vegh (2007), in this article, I focus on credit frictions rather than asset market segmentation. In addition, the results in this article show that the relative performance of floating versus fixed exchange rates depends more on the correlation of shocks across countries than on the type of shocks considered (real vs. monetary).…”