Balance Sheets, Exchange Rate Policy, and Welfare

Selim Elekdag and Ivan Tchakarov

No 2004/063, IMF Working Papers from International Monetary Fund

Abstract: The debate about the appropriate choice of exchange rate regime is fundamental in international economics. This paper develops a small open-economy model with balance sheet effects and compares the performance of fixed and flexible exchange rate regimes. The model is solved up to a second-order approximation which allows us to address the issue of risk and welfare rigorously. The paper identifies threshold levels of the debt-to-GDP ratio above which fixed exchange rate regimes are welfare superior to monetary policy rules that imply flexible exchange rate regimes. The results suggest that emerging market economies that suffer from a relatively high level of indebtedness and are constrained in their pursuit of optimal monetary policy, could find it beneficial to opt for a fixed exchange rate regime.

Keywords: WP; exchange rate; risk premium; open economy; Exchange rate policy; financial accelerator; debt-to-GDP threshold; second-order approximation; market power; price level; exchange rate uncertainty; utility function; transmission mechanism; exchange rate movement; nominal exchange rate depreciation; home economy; main exchange rate regime; optimal exchange rate regime; inflation targeting rule; inflation rate; Exchange rate arrangements; Exchange rate flexibility; Conventional peg; Consumption; Return on investment; East Asia (search for similar items in EconPapers)
Pages: 37
Date: 2004-04-01
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (24)

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