Working Paper: NBER ID: w7738
Authors: Joshua Aizenman; Ricardo Hausmann
Abstract: This paper investigates the design of an exchange rate policy for an economy where the domestic capital market is segmented from the global financial market, producers rely on credit to finance working capital needs, and the labor market is characterized by nominal contracts. We show that the choice of an exchange rate regime is intertwined with the financial structure -- greater reliance on working capital to finance input needs, and greater segmentation of the domestic capital market increase the desirable exchange rate stability. This result follows from the observation that greater exchange rate stability is likely to reduce the real interest rate facing the producer, thereby increasing output. Hence, greater reliance on working capital increases the welfare gain attached to the lower interest rate associated with lower flexibility of the exchange rate, thereby increasing the desirability of a fixed exchange rate. Similarly, greater integration with the global capital market reduces the real interest rate benefits from exchange rate stability, increasing thereby the optimal flexibility of the exchange rate, and reducing the demand for international reserves.
Keywords: No keywords provided
JEL Codes: F31; F32; F36
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| greater reliance on working capital financing (G32) | increased desirability of exchange rate stability (F31) |
| increased desirability of exchange rate stability (F31) | reduced real interest rates (E43) |
| reduced real interest rates (E43) | increased output (E23) |
| greater integration with the global capital market (F30) | increased exchange rate flexibility (F31) |
| increased exchange rate flexibility (F31) | reduced demand for international reserves (F31) |
| volatility of nominal shocks (E39) | optimal degree of exchange rate flexibility (F31) |
| loss associated with inflation (E31) | optimal degree of exchange rate flexibility (F31) |
| discretionary policy bias (E60) | optimal degree of exchange rate flexibility (F31) |