Working Paper: CEPR ID: DP1962
Authors: Philippe Bacchetta; Eric van Wincoop
Abstract: On the eve of a major change in the world monetary system, the adoption of a single currency in Europe, our theoretical understanding of the implications of the exchange rate regime for trade and capital flows is still limited. We argue that two key model ingredients are essential to address this question: a general equilibrium set-up and deviations from purchasing power parity. By developing a simple benchmark monetary model that contains these two ingredients, we find the following main results. First, the level of trade is not necessarily higher under a fixed exchange rate regime. Second, the level of net capital flows tends to be higher under a fixed exchange rate regime when there is a preference for domestic bonds, which is the case when the rate of relative risk-aversion is larger than one. Third, the asset market structure, including the presence of a forward market, does not qualitatively affect the results.
Keywords: exchange rate; uncertainty; trade; capital flows
JEL Codes: F31; F33; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exchange rate regime (F33) | level of trade (F19) |
| exchange rate regime (F33) | net capital flows (F32) |
| exchange rate volatility (F31) | net capital flows (F32) |