Working Paper: NBER ID: w10827
Authors: Andrés Velasco; Roberto Chang
Abstract: Exchange rate policies depend on portfolio choices, and portfolio choices depend on anticipated exchange rate policies. This opens the door to multiple equilibria in policy regimes. We construct a model in which agents optimally choose to denominate their assets and liabilities either in domestic or in foreign currency. The monetary authority optimally chooses to float or to fix the currency, after portfolios have been chosen. We identify conditions under which both fixing and floating are equilibrium policies: if agents expect fixing and arrange their portfolios accordingly, the monetary authority validates that expectation; the same happens if agents initially expect floating. We also show that a flexible exchange rate Pareto-dominates a fixed one. It follows that social welfare would rise if the monetary authority could precommit to floating.
Keywords: No keywords provided
JEL Codes: E42; F41; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Agents' expectations of floating exchange rates (F31) | Central bank's optimal policy to float (E63) |
| Agents' expectations of fixed exchange rates (F33) | Central bank's optimal policy to fix (E52) |
| Expectations of exchange rate policy (F31) | Portfolio choices (G11) |
| Portfolio choices (G11) | Central bank's policy decisions (E52) |
| Existence of currency mismatches (F31) | Equilibrium outcomes (D50) |
| Policy regimes (L50) | Expected welfare (D69) |
| Central bank precommitting to floating (F33) | Social welfare (I38) |
| Fixed rates equilibrium (E43) | Inefficiently low expected welfare (D69) |
| Multiple equilibria in policy regimes (D50) | Pareto-ranked outcomes (D63) |
| Flexible exchange rates (F31) | Dominance over fixed rates in expected welfare (D69) |