Faculty of Economics and Business Administration Publications Database

Financial Frictions and the Choice of Exchange Rate Regimes

Volume: 48
Number: 4
Pages: 965 - 982
Month: October
ISSN-Print: 0095-2583
Link External Source: Online Version
Year: 2010

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.