A Risk-Based Theory of Exchange Rate Stabilization

83 Pages Posted: 7 Aug 2016 Last revised: 22 May 2020

See all articles by Tarek A. Hassan

Tarek A. Hassan

Boston University; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Thomas M. Mertens

Federal Reserve Bank of San Francisco

Tony Zhang

Board of Governors of the Federal Reserve System

Multiple version iconThere are 3 versions of this paper

Date Written: May 19, 2020

Abstract

We develop a novel, risk-based theory of the effects of currency manipulation. 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 international 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 currency 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: fixed exchange rate, managed float, exchange rate stabilization, uncovered interest parity, currency returns

JEL Classification: E4, E5, F3, F4, G11, G15

Suggested Citation

Hassan, Tarek Alexander and Mertens, Thomas M. and Zhang, Tony, A Risk-Based Theory of Exchange Rate Stabilization (May 19, 2020). Available at SSRN: https://ssrn.com/abstract=2819214 or http://dx.doi.org/10.2139/ssrn.2819214

Tarek Alexander Hassan

Boston University ( email )

270 Bay State Road
Boston, MA 02215
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
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Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Thomas M. Mertens (Contact Author)

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

Tony Zhang

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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