Balance Sheets, Exchange Rate Policy, and Welfare

37 Pages Posted: 15 Feb 2006

See all articles by Selim Ali Elekdag

Selim Ali Elekdag

International Monetary Fund (IMF) - Policy Development and Review Department

Ivan Tchakarov

International Monetary Fund (IMF) - Asia and Pacific Department

Date Written: April 2004

Abstract

The debate about the appropriate choice of exchange rate regime is fundamental in international economics. This paper develops a small open-economy model with balance sheet effects and compares the performance of fixed and flexible exchange rate regimes. The model is solved up to a second-order approximation which allows us to address the issue of risk and welfare rigorously. The paper identifies threshold levels of the debt-to-GDP ratio above which fixed exchange rate regimes are welfare superior to monetary policy rules that imply flexible exchange rate regimes. The results suggest that emerging market economies that suffer from a relatively high level of indebtedness and are constrained in their pursuit of optimal monetary policy, could find it beneficial to opt for a fixed exchange rate regime.

Keywords: Exchange rate policy, financial accelerator, debt-to-GDP threshold, second-order approximation

JEL Classification: F31, F41

Suggested Citation

Elekdag, Selim Ali and Tchakarov, Ivan, Balance Sheets, Exchange Rate Policy, and Welfare (April 2004). IMF Working Paper, Vol. , pp. 1-37, 2004. Available at SSRN: https://ssrn.com/abstract=878886

Selim Ali Elekdag (Contact Author)

International Monetary Fund (IMF) - Policy Development and Review Department ( email )

700 19th St. NW
Washington, DC 20431
United States

Ivan Tchakarov

International Monetary Fund (IMF) - Asia and Pacific Department ( email )

700 19th Street NW
Washington, DC 20431
United States

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