A Risk-based Theory of Exchange Rate Stabilization

Tarek Hassan, Thomas M. Mertens and Tony Zhang

No 22790, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We develop a novel, risk-based theory of the effects of exchange rate stabilization. In our model, the choice of exchange rate regime allows policymakers to make their currency, and by extension, the firms in their country, a safer investment for international investors. Policies that induce a country's currency to appreciate when the marginal utility of inter- national investors is high lower the required rate of return on the country's currency and increase the world-market value of domestic firms. Applying this logic to exchange rate stabilizations, we find a small economy stabilizing its bilateral exchange rate relative to a larger economy can increase domestic capital accumulation, domestic wages, and even its share in world wealth. In the absence of policy coordination, small countries optimally choose to stabilize their exchange rates relative to the currency of the largest economy in the world, which endogenously emerges as the world's \anchor currency." Larger economies instead optimally choose to float their exchange rates. The model therefore predicts an equilibrium pattern of exchange rate arrangements that is remarkably similar to the one in the data.

JEL-codes: E4 E5 F3 F4 G11 G15 (search for similar items in EconPapers)
Date: 2016-10
New Economics Papers: this item is included in nep-mac and nep-opm
Note: AP EFG IFM ME
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Citations: View citations in EconPapers (6)

Published as Tarek A Hassan & Thomas M Mertens & Tony Zhang, 2023. "A Risk-based Theory of Exchange Rate Stabilization," The Review of Economic Studies, vol 90(2), pages 879-911.

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Journal Article: A Risk-based Theory of Exchange Rate Stabilization (2023)
Working Paper: A Risk-based Theory of Exchange Rate Stabilization (2020)
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