A Risk-based Theory of Exchange Rate Stabilization

Tarek Hassan, Thomas Mertens and Tony Zhang
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Tony Zhang: https://www.federalreserve.gov/econres/tony-zhang.htm

No 2016-15, Working Paper Series from Federal Reserve Bank of San Francisco

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 international 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 oat their exchange rates. The model therefore predicts an equilibrium pattern of exchange rate arrangements that is remarkably similar to the one in the data.

Keywords: managed float; exchange rate stabilization; uncovered interest parity; currency returns; fixed exchange rates (search for similar items in EconPapers)
JEL-codes: E4 E5 F3 F4 G11 G15 (search for similar items in EconPapers)
Pages: 84 pages
Date: 2020-05-01
Note: Published originally 12/2016 as “Currency Manipulation", FRBSF Working Paper 2016-16.
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Citations: View citations in EconPapers (16)

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Related works:
Journal Article: A Risk-based Theory of Exchange Rate Stabilization (2023)
Working Paper: A Risk-based Theory of Exchange Rate Stabilization (2016)
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DOI: 10.24148/wp2016-15

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