Trade and Welfare under Alternative Exchange-Rate Systems

This paper evaluates the two standard alternative exchange rate regimes, fixed and flexible, in a stochastic dynamic general equilibrium two-country setting. Conventional wisdom holds that countries often prefer low exchange-rate variability to stabilize trade. This may explain the observed ’fear of floating’ in emerging markets: although most of them claim to adopt a flexible system, in reality they frequently intervene to peg. We show that under incomplete capital markets a fixed exchange rate regime unambiguously increases trade and improves welfare and, thus, it rationalizes the behavior of policy makers in emerging markets. ∗I am thankful to Carlos Végh, Amartya Lahiri, and Matt Doyle for helpful comments and suggestions. All remaining errors are mine. Address for correspondence: Department of Economics, 260 Heady Hall, Iowa State University, Ames IA 50011; E-mail: [email protected]