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FINANCIAL FRICTIONS AND THE CHOICE OF EXCHANGE RATE REGIMES

Authors

  • ESTER FAIA

    1. Faia: Chair in Monetary and Fiscal Policy, Department of Money and Macroeconomics, House of Finance, Goethe University Frankfurt, Campus Westend, Grueneburgplatz 1, Frankfurt 60323, Germany. E-mail faia@wiwi.uni-frankfurt.de; Kiel Institute for the World Economy; and CEPREMAP.
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      I thank Ignazio Angeloni, William Baumol, Pierpaolo Benigno, Thomas Cooley, Carsten Detken, Günter Coenen, Mark Gertler, Philipp Hartmann, Tommaso Monacelli, and Frank Smets for useful discussions. I thank seminar participants at the European Central Bank, New York University, Ente Einaudi, 2001 SED Conference in Stockholm, 2001 EEA Conference in Lausanne, and 2001 MMF Conference in Belfast. I gratefully acknowledge financial support from the Dynamic Stochastic General Equilibrium (DSGE) model grant of the Spanish Ministry of Education and the Unicredit research grant. This article has been previously circulated as European Central Bank (ECB) w.p. Number 56 in April 2001. All errors are mine.


Abstract

This article provides a quantitative assessment of the role of financial frictions in the choice of exchange rate regimes. I use a two-country model with sticky prices to compare different exchange rate arrangements. I simulate the model without and with borrowing constraints on investment, under monetary policy and technology shocks. I find that the stabilization properties of floating exchange rate regimes in face of foreign shocks are enhanced relative to fixed exchange rate in presence of credit frictions. In presence of symmetric and correlated shock, fixed exchange rates regimes can perform better than floating. This analysis can have important policy implications for accession countries joining the European Exchange Rate Mechanism II system and with high degrees of credit frictions. (JEL E3, E42, E44, E52, F41)

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