Exchange Rate Regimes and Financial-Market Imperfections
UCSC Dept. of Economics Working Paper No. 493
20 Pages Posted: 29 Oct 2001
There are 2 versions of this paper
Exchange Rate Regimes and Financial-Market Imperfections
Exchange Rate Regimes and Financial-Market Imperfections
Date Written: March 2001
Abstract
This paper investigates the design of an exchange rate policy for an economy where the domestic capital market is segmented from the global financial market, producers rely on credit to finance working capital needs, and the labor market is characterized by nominal contracts. We show that the choice of an exchange rate regime is intertwined with the financial structure -- greater reliance on working capital to finance input needs, and greater segmentation of the domestic capital market increase the desirable exchange rate stability. This result follows from the observation that greater exchange rate stability is likely to reduce the real interest rate facing the producer, thereby increasing output. Hence, greater reliance on working capital increases the welfare gain attached to the lower interest rate associated with lower flexibility of the exchange rate, thereby increasing the desirability of a fixed exchange rate. Similarly, greater integration with the global capital market reduces the real interest rate benefits from exchange rate stability, increasing thereby the optimal flexibility of the exchange rate, and reducing the demand for international reserves.
Keywords: Exchange rate regimes, Financial imperfections, Working Capital
JEL Classification: F31, F36
Suggested Citation: Suggested Citation
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