Working Paper: NBER ID: w22790
Authors: Tarek A. Hassan; Thomas M. Mertens; Tony Zhang
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.
Keywords: exchange rate stabilization; currency manipulation; capital accumulation; international investors; risk premia
JEL Codes: E4; E5; F3; F4; G11; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Exchange rate regime choice (F33) | Required rate of return on currency (F31) |
| Marginal utility of international investors (F29) | Required rate of return on currency (F31) |
| Exchange rate regime choice (F33) | World market value of domestic firms (F23) |
| Marginal utility of international investors (F29) | World market value of domestic firms (F23) |
| Exchange rate stabilization (F31) | Domestic capital accumulation (E22) |
| Required rate of return on currency (F31) | Domestic capital accumulation (E22) |
| Exchange rate stabilization (F31) | Domestic wages (J31) |
| Required rate of return on currency (F31) | Domestic wages (J31) |
| Exchange rate stabilization relative to the US dollar (F31) | Domestic interest rates (E43) |
| Exchange rate stabilization relative to the US dollar (F31) | Capital intensity (E22) |
| Size of the economy (E20) | Choice of exchange rate regime (F33) |
| Choice of exchange rate regime (F33) | Exchange rate arrangements (F33) |
| Choice of exchange rate regime (F33) | Status of the currency as an anchor (F31) |