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Does exchange rate stability increase trade and capital flows?

Author

Listed:
  • Philippe Bacchetta
  • Eric Van Wincoop
Abstract
On the eve of a major change in the world monetary system, the adoption of a single currency in Europe, our theoretical understanding of the implications of the exchange rate regime for trade and capital flows is still limited. We argue that two key model ingredients are essential to address this question: a general equilibrium setup and deviations from purchasing power parity. By developing a simple benchmark monetary model that contains these two ingredients, we find the following main results. First, the level of trade is not necessarily higher under a fixed exchange rate regime. Second, the level of net capital flows tends to be higher under a fixed exchange rate regime when there is a preference for domestic bonds, which is the case when the rate of relative risk-aversion is larger than one. Third, the asset market structure, including the presence of a forward market, does not qualitatively affect the results.

Suggested Citation

  • Philippe Bacchetta & Eric Van Wincoop, 1998. "Does exchange rate stability increase trade and capital flows?," Research Paper 9818, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednrp:9818
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    References listed on IDEAS

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    More about this item

    Keywords

    Foreign exchange rates; European Monetary System (Organization); Monetary policy; Capital movements;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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