Chapter

CHAPTER 2 Financial Market Integration and Exchange Rate Policy

Author(s):
International Monetary Fund
Published Date:
September 1990
Share
  • ShareShare
Show Summary Details
Author(s)
Donald J. Mathieson and Liliana Rojas-Suárez* 

I. Introduction

One of the major structural changes in the international economy during the past two decades has been the growing integration of capital markets in the industrial countries. This integration has reflected both the dismantling of capital controls and the removal of restrictions that have limited competition or asset price flexibility in domestic financial markets. The extensive liberalization of restrictions on cross-border financial transactions, in particular, stands in sharp contrast to the limited progress (or, in some cases, regression) that has been evident in reducing barriers to trade in goods and services.

As restrictions on domestic and external financial transactions have been lowered, financial markets have helped magnify the short-run spillover effects of domestic macroeconomic policies on neighboring countries. At the same time, the institutional changes brought about by financial liberalization may have weakened the authorities’ ability to respond to those spillover effects. In particular, questions have been raised about whether the effectiveness of traditional macroeconomic policy instruments has been reduced, whether exchange rate arrangements and intervention strategies need to be altered, and whether the coordination of macroeconomic policies among the major countries needs to be increased.

This paper examines one aspect of these policy issues: namely, how a country’s exchange rate policy should be adjusted when the degree of integration between domestic and external financial markets increases as a result of both domestic financial liberalization and the relaxation of capital controls.1 It is interesting to note that rather different approaches for solving this policy problem are being adopted in Europe and North America. The Delors Report (1989) has recommended that, in order for the members of the European Monetary System (EMS) to enjoy the full benefits of financial market integration, they should maintain a system of relatively fixed exchange rates between themselves.2 In contrast, although the United States-Canada Free Trade Agreement contains provisions that significantly reduce or eliminate barriers to financial transactions between residents of the two countries, the Canadian authorities seem committed to a relatively flexible exchange rate policy vis-à-vis the United States and other countries. These different approaches leave unanswered the question of what exchange rate arrangements should be adopted by countries on the “periphery” of these large trading blocs, especially if these peripheral countries are also planning to reduce their capital controls and undertake domestic financial reforms.

Our analysis of the relationship between financial liberalization and exchange rate policy is divided into four sections. Section II briefly considers how the recent changes in capital controls and domestic financial regulations in the industrial countries have altered the terms and conditions under which borrowers can obtain funds from domestic and external financial markets. Section III develops a relatively simple model of real and financial sector linkages in an open economy; the model is used to provide a framework for analyzing how the changes in financial structure induced by the removal of capital controls and the liberalization of domestic financial market restrictions can influence optimal exchange rate arrangements. In the model, a financial constraint arises from the assumption that firms use credit from commercial banks to finance their working capital needs prior to the sale of their output.3 In Section IV, this model is used to identify the exchange rate arrangements that best insulate the economy from domestic and foreign real and financial market shocks under three alternative assumptions about the economy’s financial structure:

  • (1) when the economy has highly restrictive capital controls and places extensive restrictions on the domestic financial system;

  • (2) when the authorities undertake a partial liberalization of domestic interest rates and the removal of some capital controls; and

  • (3) when there is a complete removal of capital controls and the elimination of all restrictions on domestic interest rates.4

To examine the role of creditworthiness considerations in influencing exchange rate arrangements, cases (2) and (3) are analyzed in circumstances where international lenders either do or do not find it profitable to “credit-ration” domestic borrowers. Two important results are obtained. First, as the economy’s financial structure is opened and liberalized the optimal scale of exchange rate intervention will change as the relative importance of different domestic and foreign shocks for output and price stability is altered. Moreover, although the optimal scale of exchange market intervention can vary with the financial structure, there is nonetheless a similarity in the response of the optimal degree of intervention to increases in the variances of domestic and foreign shocks across all financial structures. The final section of the paper summarizes our main conclusions and considers certain unresolved issues.

II. Liberalization and Structural Change in Major Financial Markets

Since the mid-1970s, the authorities in industrial countries have eliminated or weakened many of their restrictions on external and domestic financial transactions.5 This liberalization has reflected both the desire to engender greater competition and efficiency in domestic financial markets and a recognition that many large financial and nonfinancial institutions were increasingly turning toward the less regulated offshore markets to meet their financial needs. Although the specific financial liberalization measures have naturally differed across countries, there have been several common features: the elimination of barriers to market access; the removal of restrictions on the activities, products, and location of financial institutions; and greater reliance on market-determined interest rates.

This process of liberalization has fundamentally altered the financial structures of the major industrial countries and has forged new linkages between the financial markets in these countries. Increased competition has forced many financial entities to reexamine the range of financial services and products they can profitably produce. The competition for new customers has often involved the creation of new financial products and services. While many of these innovations quickly pass from the scene, this competition has greatly facilitated both the efforts of portfolio managers to achieve an internationally diversified portfolio, and the search of corporate (and sovereign) treasurers for the lowest cost source of funds.

Despite the removal of capital controls and the liberalization of domestic financial markets, however, different categories of borrowers still often face divergent terms and conditions under which they can access foreign and domestic sources of funds. Access to borrowed funds is typically affected both by official restrictions on market access (including capital controls) and by the lenders’ evaluation of the borrower’s creditworthiness. The liberalization measures undertaken in recent years imply that, to an important degree, creditworthiness considerations have now replaced capital controls and other official restrictions on market access as the principal limitation on an individual borrower’s access to funds. Creditworthiness considerations affect both the cost of borrowing (owing to the presence of a premium reflecting default risk) and the availability of funds. In particular, access to some markets may be curtailed for certain classes of borrowers even in the absence of government restrictions. For example, only sovereign and large corporate borrowers that are regarded as good credit risks can issue on the Eurobond markets. Thus, while most borrowers can now seek funds from a broader range of domestic and international institutions than in the pre-reform period, the “small-country” assumption that they can borrow unlimited amounts at a fixed international interest rate would not be an appropriate characterization of the terms and conditions under which most borrowers can access international markets.

The presence of such market-imposed limitations on the availability of funds is not inconsistent with the evidence that covered interest rate differentials have been arbitraged away on comparable short-term instruments and sharply narrowed on equivalent medium- and long-term instruments.6 The elimination of covered interest rate differentials indicates that a borrower with a given credit rating can obtain funds at a cost that is identical across markets in different countries and when using instruments denominated in different currencies. Nonetheless, this does not rule out the fact that borrowers with different credit ratings must pay different risk premiums; nor is it inconsistent with the fact that as the amount of debt issued by a single borrower increases lenders would typically become more concerned about the borrower’s ability or willingness to pay. While these concerns would be reflected in higher borrowing costs, the lender may strictly limit the availability of funds to a borrower when the expected profit on an additional dollar of lending (even at a higher interest rate) is reduced to zero because the probability of default would be increased sufficiently to offset the higher interest income associated with the additional lending.

Whether such “equilibrium” credit rationing is a valid characterization of the situation confronting borrowers on international markets is open to debate.7 Even if credit rationing were evident, it is unlikely that all borrowers would face the same degree of rationing. Nonetheless, the nature of the terms and conditions under which domestic borrowers can access international markets could have a strong bearing on the degree of exchange market intervention that would best stabilize domestic income or prices as a country undertakes a financial liberalization and opens to external financial transactions.

III. Basic Model

This section develops a simple model that incorporates crucial linkages between real activity, domestic financial intermediation, and external financial and goods markets. The model seeks to identify the exchange rate policy that would impart the greatest stability to either domestic output or the price level in the face of various domestic and foreign shocks as domestic financial restrictions (for example, interest rate ceilings) and controls on international capital flows are removed. What is ideally needed to analyze this policy issue is a multicountry model of large economies that specifies the linkages between the real and financial sectors both within and across countries. As the complexities involved in developing such models are well-known, we have a more modest first objective of focusing on the linkages between the real and financial sector in a single open country and considering how changes in those linkages affect exchange rate policy. Our model, therefore, necessarily abstracts from many of the complex real and financial sector linkages that exist in a modern industrial economy. Moreover, since our focus is on the design of exchange rate policy, we do not explicitly consider the case where the authorities have decided to commit to a fixed exchange rate arrangement (such as the EMS) and use other policy instruments (for example, the required reserve ratio) to stabilize the economy. However, the model could be used to analyze this situation.

General Framework

The economy that we analyze consists of three sectors: firms, households, and banks.8 Firms are owned by entrepreneurs who produce a single tradable good using their own capital and the labor services of workers from the household sector. The entrepreneur’s objective is to maximize the expected discounted value of the utility of his consumption over time. Entrepreneurs also borrow from banks to finance their payments of wages prior to the sale of their output. This short-term working capital borrowing must be repaid to the bank, with interest, after the entrepreneur’s output is sold. The firm’s profits are used to purchase investment goods and for the entrepreneur’s consumption. Each firm’s output is assumed to be subject to an exogenous production shock, so there is some probability that the entrepreneur will be unable to service his debt obligations.9

Banks accept deposits from households, acquire funds from abroad (subject to the limitations imposed by capital controls), make loans to firms, and attempt to maximize expected profits. The banks are assumed to recognize that, since firms are subject to random production shocks, some entrepreneurs may default on their loan obligations. This risk leads the banks to evaluate the loan applications of each firm ex ante (to understand the firm’s investment plans and its vulnerability to production shocks), and also to monitor any reported defaults ex post (to ensure truthfulness). The possibility of default implies the banks might engage in equilibrium credit rationing (that is, they may at some point refuse to lend more to a firm even if it offers to pay a higher interest rate). Such credit rationing arises when the bank perceives that additional lending raises the expected loss of revenue through default by more than the expected gain in revenue associated with the higher interest rate.

When domestic banks are allowed to borrow abroad, international lenders are assumed to recognize that the domestic banks will use the external funds they obtain to make loans to domestic firms. The international creditworthiness of domestic banks is therefore evaluated in terms of the probability that the banks’ domestic customers would be able to service their debts.10 As a result, the international lenders would add a default risk premium to the risk-free international interest rate in order to determine the loan rate charged domestic banks. While this risk premium would rise as the amount of borrowing by domestic banks increased, the international lenders might also engage in equilibrium credit rationing of the domestic banks.

Households use their income—derived from providing labor services and from interest earned on their deposits with banks and foreign assets—to finance their consumption and to increase their holdings of domestic deposits and foreign assets.11 They attempt to maximize the expected discounted value of their utility over time, which depends positively on consumption and negatively on labor effort. When capital controls are removed and households can hold foreign assets, households adjust their holdings of domestic deposits and foreign assets so as to equate the expected risk-adjusted yields on the two instruments.

The authorities are assumed to affect domestic behavior through three channels: the establishment of capital controls that limit external financial transactions; the impositions of restrictions on the domestic financial system; and the formulation of exchange rate policy. As already noted, our analysis considers the cases where capital controls either effectively eliminate external financial transactions, allow domestic banks limited access to international markets, or are totally removed. The effects of restrictions on the domestic financial system are examined in terms of the presence or absence of ceiling loan and deposit interest rates. Monetary and exchange rate policies are linked via an exchange market intervention function that relates changes in the domestic stock of base money to exchange rate movements.

Exchange rate policy is analyzed under three alternative assumptions about the economy’s financial structure. In the first case, it is assumed that the economy is closed to external financial transactions, through the use of effective capital controls, and has a domestic financial system that is constrained by official interest rate ceilings (on banks’ loan and deposit interest rates) and high required reserve ratios. Domestic borrowers are therefore faced with “disequilibrium” credit rationing, in the sense that the demand for credit at the ceiling interest rates exceeds the available supply and the interest rate charged borrowers does not appropriately reflect the opportunity cost of borrowed funds.

The second case that is examined is an economy with a partially open and liberalized financial system, in which domestic banks are allowed to borrow abroad (subject to certain limitations) and the domestic loan rate is freed from official controls. However, the domestic deposit rate is still subject to an official ceiling, and capital controls are assumed to prevent domestic depositors from moving their funds abroad.12 While this partial removal of capital controls allows domestic banks access to international markets, the markets’ evaluation of the domestic borrower’s creditworthiness is a crucial determinant of the nature of this access. To analyze the role of creditworthiness considerations, the optimal exchange rate arrangements for a partially liberalized economy are examined both when domestic borrowers are credit-rationed by foreign lenders (that is, they would like to borrow more at prevailing international interest rates but cannot) and when domestic borrowers are not credit-rationed. If “equilibrium” credit rationing exists, it would reflect the profit-maximizing decisions of lenders rather than any official restriction or constraint.

In the third case, the formulation of exchange rate policy is considered for a completely open and liberalized domestic financial system in which all capital controls and domestic interest rate ceilings have been removed. Once again, however, domestic borrowers may or may not be subjected to “equilibrium” credit rationing by international lenders.

It should be stressed that our analysis of the design of exchange rate policy is focused on the issue of what exchange rate arrangements would over time stabilize output or prices, rather than what type of short-term exchange market intervention would best offset a specific shock. As a result, our concern is with the effects of alternative exchange rate arrangements on the equilibrium levels of output, prices, and interest rates that will prevail in the face of different patterns of foreign and domestic shocks.

Structural Relationships

The economic structure described above can be represented by the following set of relationships:

where

and13

  • yt = level of output in period t

  • pt = price level in period t

  • Ept + 1Pt = expected inflation rate

  • pt* = foreign price level in period t

  • ht = monetary base in period t

  • mt = stock of money in period t

  • bts = supply of domestic credit in period t

  • ft = foreign credit to domestic banks measured in domestic currency

  • st = exchange rate measured as the domestic price of a unit of foreign currency

  • Est+1−st = expected future change in the exchange rate

  • rb,t = domestic loan rate in period t

  • rm,t = domestic deposit rate in period i

  • rft = foreign interest rate charged to domestic banks in period t

  • it* = foreign risk-free rate in period t

  • pt = risk premium charged by foreign lenders to domestic banks in period t

  • K = required reserve ratio

  • nt, ∈tvtgt and Xt = random shocks.

E is the expectations operator. When placed in front of a variable it represents the expected value of such variable conditioned on information available up to period t. Expectations are fully rational in the sense that the expected exchange rate and price level are consistent with the model’s structural relationships.

Equations (1a) and (1b) represent semi-reduced form supply functions for domestic output when firms either are or are not credit-rationed. The derivation of these relationships—which reflect both production functions and the conditions for labor market equilibrium—is presented in Appendix I.14 When firms are credit-rationed, the supply of domestic output (yts. would be a positive function of the stock of real credit (btspt). This reflects the fact that since firms must make wage payments in advance of their sales of output, credit rationing limits the amount of labor they can employ. In this situation, the firms’ demand for labor would be determined by the amount of real credit available and the real wage rate they must pay. In addition, output would depend positively on real production shocks (nt) and on the expected real return on deposits (rm,t−Ept+1+pt). Since the households’ supply of labor is assumed to be a positive function of the real wage and the expected real return on deposits,15 a higher expected real return on deposits would increase the supply of labor and thereby the supply of output.

Equation (1b) represents the supply of output when domestic firms are not credit-rationed. In this case, firms can achieve their desired levels of borrowing and output at the prevailing set of prices, wage rate, and interest rates (see Appendix I). Although the real stock of credit would no longer impose an exogenous constraint on their activities, the level of the nominal loan rate would affect the amount of borrowing that the firms would undertake to satisfy their need for working capital.16 As a result, the firms’ demand for labor and for working capital loans would be a negative function of the real wage rate and the loan rate. In this situation, the conditions for labor market equilibrium imply that the supply of output would depend negatively on the loan rate. Moreover, just as in the credit-rationing case, the supply of output would also depend positively on real production shocks and the expected real return on deposits.

Equation (2) assumes that purchasing power parity holds apart from a white noise shock. Thus, changes in the domestic price level (pt) are determined by movements in the exchange rate (st), the international price of goods (pt*), and a random shock (εt).17 The demand for money, represented by equation (3), is taken to be a positive function of the level of nominal income (pt+yts) and the expected real return on money (rm,t − Ept + 1+ pt) and is affected by a random shock (vt).18

To simplify the analysis, we will assume a direct relationship between the stock of base money (ht), the money supply (mt), and the stock of domestic credit (bts). In particular, banks are to be subject to a required reserve ratio of K percent on domestic deposits. 19 Since the authorities do not pay interest on required reserves and banks are taken as maximizing expected profits, they do not hold any excess reserves.20 Moreover, since households are assumed to hold all of their money in the form of interest-earning deposits rather than currency, the entire monetary base is held as reserves by commercial banks. In this situation, the supply of credit is given by equation (4),21 and the stock of domestic money is given by equation (5) (in log form).

Exchange rate policy is represented by the reaction function in equation (6), which relates the stock of base money to an exogenous component and to movements in the exchange rate. The parameter Φ would take on the value zero with a flexible exchange rate and (in an absolute value sense) would be infinite with a fixed exchange rate.

Equations (710) describe the economy’s interest rate structure. Three alternative structures are examined. For the economy that is closed to external financial transactions and whose financial system is heavily regulated, domestic loan (rb,t) and deposit (rm,t) interest rates would be constrained by ceilings established by the authorities (denoted by a bar over the interest rate). For the partially liberalized and opened economy, it is still assumed that the domestic deposit interest rate is constrained by an interest rate ceiling. However, the domestic loan rate would be linked to the international loan rate that international lenders charge domestic banks. Equation (7) states that deviations of the domestic loan interest rate from interest rate parity are solely accounted for by the remaining capital control (ө), which is assumed to take the form of a proportional tax on borrowing from abroad. As represented by equation (8), the interest rate charged domestic banks by international borrowers (rf,t) would reflect the risk-free international interest rate (it*), any random component of the risk-free rate (gt),22 and the risk premium (pt) that foreign lenders would attach to reflect the probability that the domestic banks would default on their obligations.

As was argued earlier, the probability that the domestic banks would default on their obligations reflects the probability that the domestic firms would be unable to service their debts. In this situation, Appendix II shows that the determinants of the risk premium that would reflect the probability of default would differ depending on whether international lenders credit-ration domestic banks. When there is credit rationing, this risk premium would be positively related to both the level of the domestic loan rate and the real stock of credit, and negatively related to the expected real return on deposits (equation (9a)). The positive effects of the loan rate and the real stock of credit arise because higher values of these variables increase the scale of the domestic firms’ debt service obligations and thereby increase the probability that an adverse shock to production would leave firms unable to service those debt obligations. In contrast, a higher expected real deposit rate would, in a general equilibrium context, increase the supply of labor23 and reduce the real wage confronting firms, thereby allowing them better to service their debts. When there is no credit rationing, firms can achieve their desired level of borrowing, which will be a function of the level of the loan rate and the real wage (see Appendix I). In this situation, equation (9b) indicates that the risk premium would be a positive function of the loan rate (since the firm’s debt service obligations would be higher) and a negative function of the expected real return on deposit (since this would increase the supply of labor and reduce the real wage facing the firm).

Finally, in the case of a completely open and liberalized economy, all capital controls are removed and depositors would be free to substitute between holding domestic deposits and foreign assets. If households are risk-neutral, they would adjust their holdings of these assets until the expected risk-adjusted yield on each instrument was identical. Just as foreign lenders, domestic depositors would want to earn a return on domestic deposits that would compensate for the risk that domestic banks would default on their obligations to foreign creditors and domestic depositors.24 To simplify, we will assume that depositors’ evaluation of the banks’ default risk is the same as that of the foreign creditors. As indicated in equation (10), this implies that the domestic deposit rate (rm,t) would equal the nominal loan rate (rb,t) less real intermediation costs (ω). In addition, the deposit rate is assumed to be affected by a random shock ((χt).25

To close the model, it is assumed that the output and money markets clear and that expectations are formed rationally in the sense that economic agents use all the relevant and available information in forming their forecasts of future price and exchange rate levels.26

IV. Exchange Rate Policy Under Alternative Financial Structures

Our model can be used to consider the type of exchange rate policy (as characterized by the value of Φ) that will best stabilize output or the domestic price level under alternative financial structures when the economy is confronted with shocks affecting foreign prices (εt), the supply of domestic output (nt), the domestic demand for money (vt), the international loan rate (gt), and the deposit rate (χt).27 Output instability is measured in terms of the variance of output around the expected steady-state level of output (E(ytsE(yts))2). In this case, the authorities’ policy problem can be represented as:

Since the expected values of all shocks in the model are zero, E(yts) would be the solution for yts when all of the error terms are dropped from the equation system.

Alternatively, the authorities might wish to stabilize the price level. Price instability is calculated similarly as the variance of the price level around its expected steady-state level (E(pt - E(pt))2). In this case, the authorities’ policy problem becomes:

While the authorities would presumably be interested in both output and price stability (with various degrees of importance attached to each objective), we will separately examine—as two polar cases—the Φs that will yield either the greatest output stability or the greatest price stability. This will allow us to identify how exchange rate policies heavily weighted in favor of one or the other of the objectives would differ and possibly conflict.

As indicated in Table 1 (and in Appendices III to VI), the optimal degree of exchange market intervention (as given by the scales and signs of the Φs) for either of the two polar objective functions depends on both the nature of the economy’s financial structure and the terms and conditions under which domestic borrowers can access international financial markets. In addition, these factors determine the types of shocks to which the Φs are sensitive. However, given the nature of the authorities’ price or output stability objective, the response of the Φs to increases in the variances of the various shocks (that is, the signs of the partial derivatives of the Φ with respect to the shock variance) tends to be similar across financial structures.

Table 1.Optimal Exchange Market Intervention
φyδφyδσ2δφyδσv2δφyδσn2δφyδσg2δφyδσ2
I. Fully controlled economy1>0 if μ2 > μ1<0>0<0
II. Partially liberalized
economy, that is
Credit-rationed1>0 if μ2 > μ1<0>0<0
Not credit-rationed2≷0≷0>0<0<
III. Fully liberalized
economy, that is
Credit-rationed3≷0≷0≷0≷0≷0≷0
Not credit-rationed4≷0≷0≷0≷0≷0≷0
φyδφpδσ2δφpδσv2δφpδσn2δφpδσg2δφpδσ2
I. Fully controlled economy1>0<0>0>0
II. Partially liberalized
economy, that is
Credit-rationed1>0<0>0>0
Not credit-rationed2≷0<0>0>0>0
III. Fully liberalized
economy, that is
Credit-rationed3≷0<0<0>0>0>0
Not credit-rationed4≶0<0>0>0>0>0

A Fully Regulated Financial System

An economy with a fully regulated financial system is assumed to be closed to external financial transactions and to have domestic interest rates subject to binding ceilings (that is, rm,t = r¯m and rb,t = b)′. In this case, equations (1a) and (26), as well as the assumption of output and money market equilibrium, characterize the economy’s structure.28 As a result, the optimal values of the exchange rate intervention parameters that would best stabilize either output or the price level, are affected by shocks to foreign prices, real output, and domestic money demand, but are unaffected by the behavior of international interest rates. The irrelevance of foreign interest rate shocks in this case reflects the assumption that domestic residents are totally cut off from international financial markets by capital controls.

Output Stability

As shown in Appendix III, the value of the exchange market intervention parameter (Φy) that minimizes output instability may be either positive or negative depending on whether the supply of output is more responsive to changes in either the real supply of credit or the real return on time deposits (see equation (1a)).29 The reasons for this ambiguity can be illustrated by considering the economy’s response to an unexpected shock that increases the demand for money. This excess demand for money would lead the exchange rate to appreciate and the price level to fall. As the domestic price level declines, the real supply of credit would rise (thereby stimulating output). However, since the domestic price level would have fallen below its long-term expected level, this would create the expectation of a future rise in prices, and this would lower the expected real return on deposits30 (thereby reducing output). If the supply-of-real-credit effect dominates (μ12), for example, then a positive money demand shock, which would lower the domestic price level, would also raise output. In contrast, if μ12, a positive money demand shock would lower both the price level and output. When the authorities want to stabilize domestic output, it is not surprising that their exchange rate policy would have to differ depending on whether a money demand shock or a foreign price shock raised or lowered income. To avoid a long taxonomy of cases in what follows, we will focus on the formulation of exchange rate policy when μ21.

If the authorities are primarily interested in stabilizing output, then Φy would generally be positive when μ21 (Table 1).31 In this case, any shock that produces an exchange rate appreciation would then lead the authorities to increase the stock of base money (see equation (6)). It has already been noted that, when μ21, any decline in the price level (which would be associated with an exchange rate appreciation) would lead to a fall in output. If the authorities therefore increase the stock of base money as the exchange rate appreciates, this would increase the supply of real money and credit; this would stimulate output, which would help offset the initial decline in output.

As indicated in Table 1, any increases in the variances of the underlying shocks would naturally influence the scale of optimal exchange market intervention. For example, an increase in the variance of foreign price shocks (a higher σ2) would lower the optimal Φy (that is, a move toward greater exchange rate flexibility). This result reflects the fact that a positive foreign price shock would initially raise the price level and increase both the expected real return on deposits and output.32 Since the higher price level would reduce the real money supply, the resulting excess demand for money would lead to an appreciation of the exchange rate. As the exchange rate appreciates, the initial rise in the price level (owing to the positive foreign price shock) would be partially offset. As a result, the expected return on deposits and output would fall. The magnitude of these offsetting effects rises as the degree of exchange rate flexibility increases. Therefore, as the variance of foreign price shocks increases, the authorities would find it optimal to rely on greater exchange rate flexibility to offset these shocks.

In contrast, an increase in the variance of money demand shocks (a higher σv2) would lead to the adoption of less exchange rate flexibility (see Appendix III). This result differs from the widely used argument that a high variance of “monetary” shocks raises the desirability of greater flexibility of exchange rates.33 Our result differs from that because many of the earlier analyses gave the authorities the objective of stabilizing consumption and have taken output as exogenous and fixed (apart from a random component).34 In our analysis, however, monetary shocks directly affect output through the assumption that real credit is needed to finance the production process. In particular, output is affected by changes in the real stock of credit and the expected real deposit rate, as well as by random output shocks (equations (1a) and (1b)). As a result, the exchange rate (and price) movements needed to restore money market equilibrium in the face of a money demand shock could affect the real return on deposits and thereby output. In fact, the closer Φy is to zero (a flexible exchange), the greater the effects of a money demand shock on the expected real return on money. In this situation, the authorities could help stabilize output by undertaking greater exchange market intervention (increasing Φy) as σv2 rose. As a result, more of any positive money demand shock would be satisfied through increases in the money supply (and therefore increases in foreign exchange reserves), rather than declines in output or a fall in the price level.

Alternatively, if the variance of output shocks (σn2) increases, output instability would be minimized by reducing Φy. A positive output shock would not only raise output but would also lead to an appreciation of the exchange rate (since it would create an excess demand for money). With μ21, any exchange rate appreciation would reduce output and thereby help offset the effects of the positive shock to the supply of output. A decline in Φy would amplify the offsetting appreciation of the exchange rate and would amplify the offsetting effect on output.

Price Stability

When the authorities are principally concerned with maintaining price stability, exchange rate policy also involves interventions that would reduce (increase) base money as the exchange rate depreciates (appreciates); Φp is therefore positive (see Appendix III).

Such a strategy would help stabilize the price level by creating money market conditions that would lead to exchange movements that offset any initial appreciation or depreciation. For example, an initial appreciation of the exchange rate would lead the authorities to increase the monetary base. This increase would create an excess money supply that would produce an offsetting depreciation of the exchange rate. In the sense that both Φy and Φp are positive, there is no fundamental conflict between the exchange market policies that will promote output and price level stability in the case of a fully regulated financial system.

As in the case when output stability was the objective, the authorities would find it optimal to reduce the scale of their intervention as the variance of foreign price shocks σ2 increases. This affords exchange rate movements greater scope to offset the effect of the foreign price shock on the domestic price level (Table 1). However, as the variances of demand for money shocks σv2 or real output shocks (σn2) increase, the authorities’ intervention in the exchange market would become more active (Φy would rise). Since a positive money demand shock (or a positive supply of output shock) would create an excess demand for money, this would lead the exchange rate to appreciate, which would drive down the domestic price level. To stabilize the domestic price level, the authorities would increase base money so as to offset the money demand shock (or the effect of a positive shock on the demand for money).

One conflict between an exchange rate policy designed to stabilize output and one designed to stabilize prices thus occurs in the optimal response to an increase in the variance of output shocks. When output stability is the objective, the authorities would reduce Φy in order to allow exchange rate movements greater scope for offsetting the initial effects of the shock on output. However, larger exchange rate adjustments would conflict with the price stability objective.

A Partially Open and Liberalized Economy

As a first step in liberalizing the country’s financial structure, the authorities are assumed to allow banks to borrow abroad and to use the proceeds to fund loans to domestic borrowers. The authorities are also assumed to free the domestic loan rate from interest rate ceilings. Some capital controls continue to exist. Domestic depositors are still prohibited from moving their funds abroad, and foreign borrowing by banks is taxed (at rate θ). Moreover, the interest rate ceiling on the deposit rate is maintained.

As the authorities begin to liberalize the domestic financial system and to open the economy to external financial transactions, exchange rate policy will for the first time be affected by the perceived creditworthiness of domestic borrowers in international markets. If domestic banks are credit-rationed by international lenders because of creditworthiness considerations, for example, they would be unable to obtain the amount of credit that they would find profitable (at existing international interest rates) to lend to domestic firms even when capital controls are weakened or eliminated. In this situation, the interest rates that the banks would be charged by international lenders would be below the “shadow” price that firms would attach to an additional dollar of credit,35 and changes in international interest rates would not affect the amount of external borrowing undertaken by domestic borrowers. 36 In contrast, if domestic borrowers are not credit-rationed,37 changes in international interest rates would affect domestic borrowers’ use of international markets.

In order to analyze how the authorities’ exchange rate arrangements are affected by creditworthiness considerations, we first consider the case when domestic banks are credit-rationed by international lenders and the case when they are not.

A Partially Liberalized Economy Facing Equilibrium Credit Rationing

If domestic banks face credit rationing by international lenders, the type of exchange rate policies that would best stabilize output or prices would not differ from those used in the fully regulated economy considered in the previous section. In terms of our model, this situation arises because, when international lenders credit-ration domestic banks (and thereby domestic firms), equations (1a) and (26) fully characterize the determinants of domestic output and prices. As already discussed, the loan rate does not represent the marginal cost of funds with credit rationing and therefore does not enter into the determination of output and prices.38 Hence, the scale of intervention would not be affected by the variability of international interest rates (σg2) or the degree to which the authorities weaken their remaining capital controls on external borrowing (as given by θ).

If international interest rate shocks do not alter private behavior because of credit rationing, exchange rate policy can be focused on mitigating the effects of shocks to foreign prices, the demand for money, and the supply of output. The similarities in the terms and conditions under which domestic borrowers can obtain additional credit in a fully regulated financial system, and in a partially open system when there is credit rationing by international lenders, leads to similar exchange market intervention strategies (Table 1). Since the rationale for these intervention strategies was discussed in the previous section, we will instead turn to the case when capital controls are relaxed and domestic borrowers are not credit-rationed.

A Partially Liberalized Economy Not Facing Equilibrium Credit Rationing

When domestic borrowers are not credit-rationed by international lenders, the economy’s structure is represented by equations (1b), (2), (3), (58), and (9b). In this case, international interest rate variability affects domestic borrowing, spending, and employment decisions (see Appendix IV). As a result, the authorities’ exchange rate arrangements would generally be designed to mitigate the effects of interest rate shocks, as well as shocks to foreign prices, output, and the demand for money.

Output Stability. If the authorities’ objective is to stabilize output, the optimal intervention parameter (Φy) would take on a positive value when the variance of monetary shocks (defined to include foreign price shocks) dominates the variances of shocks to foreign interest rates and output. This exchange rate policy arises because a positive shock to either the foreign loan rate or the demand for money leads to a decline in output that could be offset by exchange market intervention that increases the monetary base. For example, consider an unanticipated monetary shock that increases the demand for money. This excess demand for money would in turn lead to an appreciation of the exchange rate (and, as a result, a fall in output)39 in order to restore money market equilibrium. If Φy is positive, the monetary base would increase as the exchange rate appreciates. This would help restore money market equilibrium without as large an exchange rate appreciation (or fall in income).

The value of the optimal intervention parameter naturally changes as the variance of the various monetary, interest rate, and real shocks increases. When the variance of money demand shocks increases, for example, the value of the exchange rate intervention parameter would increase, implying greater exchange rate fixity.40 This occurs because, just as in the fully regulated economy, the dependence of output on the financial constraint—as well as the presence of capital market imperfections—implies that monetary shocks have real effects even under flexible exchange rates. In particular, since the nominal deposit rate is still subject to an official ceiling, a positive shock to the demand for money would result in a decline in both the real deposit rate and output as the exchange rate appreciated.41 Moreover, the exchange rate appreciation would lead to an increase in the loan rate (see equation (7)), which would induce a further decline in output. If the exchange rate instead remained fixed (that is, Φy =∞), domestic prices and the loan interest rate would remain constant, implying no change in output. The only impact of this shock would be an increase in foreign reserves. As a result, in order to stabilize output, exchange market intervention would increase as the relative variance of monetary shocks increases. This result again differs from the traditional conclusion that flexible exchange rates are optimal if monetary shocks dominate the system, in part because our objective is output rather than consumption stability.

Since exchange rate flexibility reduces the impact of real shocks on output, an increase in the variance of output shocks (σn2) would lead the authorities to reduce the scale of their exchange market intervention.42 Once again, this result contrasts with the traditional conclusion that a fixed rate would be best at stabilizing consumption in the face of greater variability of real shocks. This again reflects our output stability objective as well as our model’s linkages between output and the money market. In particular, a positive output shock would raise the demand for money and lead to an exchange rate appreciation and thereby a lower price level. Since the expected steady-state price level is not affected by transitory shocks, the decline in the price level would create the expectation of a future rise in prices (to the expected steady-state level). Such expected inflation would reduce the real deposit rate (since the nominal deposit rate is fixed) and thereby decrease output (equation (1b)). The decline in output would also be worsened by the negative effect of the rise in the loan rate induced by the initial exchange rate appreciation.43 This decline in output would at least partially offset the initial direct effects of the positive output shock. If the exchange rate was instead fixed, the price level and the loan rate would remain unaffected by the output shock, and no offsetting output adjustment would occur.

Finally, an increase in the variability of the foreign interest rate would lead the authorities to reduce their intervention in the exchange rate market. A positive shock to foreign interest rates would raise the domestic loan rate and, therefore, have a negative effect on output (equation (1b)). The decline in output would create an excess supply of money by reducing the demand for money, which would put pressure on the exchange rate to depreciate. However, since the expected steady-state exchange rate is not affected by transitory shocks, this depreciation would push the exchange rate above its expected-state value, thereby creating the expectation of a future appreciation. Such expectations would lower the domestic loan rate (equation (7)), thereby helping to offset the initial foreign interest rate shock. More exchange rate flexibility therefore helps to insulate output from foreign interest rate shocks.

Price Stability. For a partially liberalized economy whose borrowers are not subject to credit rationing, the optimal intervention parameter (Φp) is positive (negative) as the combined variances of the domestic monetary and real shocks (σm2 and (σn2)) are larger (smaller) than those for foreign price and interest rate shocks. For example, it has already been noted that a positive domestic shock (vt or nt) results in an appreciation of the exchange rate and in a reduction in the domestic price level. If Φp is positive, the monetary base would increase as the exchange rate appreciates (see equation (6)). Such monetary expansion would tend to generate an exchange rate depreciation that would offset (at least partially) the initial decline in the price level.

The effects of higher variances of the various shocks on Φp are similar to those obtained in the case of a fully controlled economy. Namely, if the variance of the domestic monetary shocks σv2 and real output shocks (σn2) rises, the authorities would find it optimal to increase the value of (Φp (Table 1). This reflects the fact that, if increased price variability arises from domestic sources, it would be optimal to move toward a fixed exchange rate and to allow the money supply to adjust readily to change in the demand for money associated with either money demand or output shocks. This would tie the price level to developments in the (relatively) more stable international economy. If instead, the variance of foreign price shocks σ2 rises relative to the variance of domestic shocks, it would be optimal to increase the insulation of domestic variables from those foreign shocks. This can be achieved by increasing the flexibility of the exchange rate, that is, by lowering the optimal value of the foreign exchange intervention parameter. In contrast, a higher variance of foreign interest rate shocks would lead the authorities to raise Φp. A foreign interest rate shock would raise the domestic loan rate and depress output. This decline in output would in turn reduce the demand for money and put pressure on the exchange rate to appreciate (which would lower the price level). To avoid this price change, the authorities would focus on stabilizing the exchange rate.

In summary, a partial liberalization of capital controls and domestic interest rate ceilings may lead to either relatively little or substantial changes in exchange rate policy. The key element determining what policy changes are required would be the nature of the terms and conditions under which domestic residents can access international financial markets. If international lenders effectively credit-ration domestic borrowers (leaving them with an excess demand for credit), the type of exchange rate policy that best stabilizes either domestic output or the price level would not be very different from that in an economy with a closed financial system. However, if domestic borrowers are not credit-rationed, they will be able to obtain their desired level of international credit (while paying a higher interest rate as they increase the scale of their borrowing to reflect increased default risk). In this situation, the formulation of exchange rate policy would be affected by changes in the variability of international interest rate shocks as well as the nature of the remaining capital controls and restrictions on the domestic financial system.

A Fully Liberalized and Open Economy

The formulation of exchange rate policy in an economy in which all capital controls and domestic interest rate ceilings have been removed needs to take into account not only the terms and conditions under which domestic borrowers can access international markets, but also the fact that domestic depositors are free to shift between holding domestic deposits and external assets. In terms of our model, the deposit rate (rm) is now endogenous (equation (10)). Moreover, in a competitive financial system, the deposit rate would differ from the loan rate only as a result of real intermediation costs (the ω in equation (10))44 and a random shock. In addition, it is assumed that the tax on foreign borrowing (θ) is set equal to zero. While the removal of capital controls would eliminate official restrictions on access to international financial markets, the formulation of exchange rate policy would still be affected by whether domestic borrowers face credit rationing by international lenders.

A Fully Liberalized Economy Facing Credit Rationing

When domestic banks are credit-rationed by international lenders, the economy’s structure is represented by equations (1a), (28), (9a), and (10). In this situation, the specification of the intervention parameter that would best stabilize domestic output becomes quite complex (see Appendix V). In part, this reflects the fact that the authorities must now respond to a broad set of international price and interest rate shocks. Moreover, similar (that is, positive) shocks to the international loan and deposit rates would have conflicting effects on the exchange rate and domestic output. As a result, knowledge of the relative sizes of the variances of the various shocks is needed to specify the optimal value of Φy.

Apart from the authorities’ response to interest rate shocks, there is also a strong similarity between optimal exchange rate arrangements that best stabilize the price level in a partially and fully liberalized economy. In part, this similarity reflects the fact that credit rationing acts as a remaining market “imperfection” in the system even when all capital controls and domestic restrictions are removed. If the variance of foreign price shocks is small relative to the combined variances of the other shocks, then Φp>0. This result reflects the fact that a positive shock to either money demand, output, the loan rate, or the deposit rate would generate a potential excess demand for money and an appreciation of the exchange rate (and a decline in the price level). Φp>0 implies that the authorities would respond to the exchange rate appreciation by increasing the monetary base, and this would lead to at least a partially offsetting depreciation of the exchange rate (and thereby the initial decline in the price level). When Φp is positive, moreover, the effects of increases in σ2, σv2, and (σn2) on the optimal value of Φp are identical (in sign) to those in the case of a partially liberalized economy facing credit rationing. In addition, the authorities would find it optimal to increase Φp when either the variance of the loan rate shocks (σg2) or the variance of the deposit rate shocks (σχ2) increases.45

A Fully Liberalized Economy Whose Borrowers Are Not Credit-Rationed by International Lenders

When domestic borrowers are not credit-rationed by international lenders, the economy is represented by equations (1b), (2), (3), (58), (9b), and (10). Although all financial controls have been relaxed and there is no credit rationing, real and financial shocks still affect the behavior of output and the price level (see Appendix VI). This reflects our initial assumption that firms need to finance their wage bill by borrowing in advance from commercial banks and that loans are repaid during the current period. This “financial constraint” implies that (as indicated in equation (1b)) the supply of output depends on the nominal loan rate.46 As a result, there is a linkage between the real and the financial sectors that does not disappear even with the removal of capital controls and interest rate ceilings.47

Since the authorities must now design their exchange rate policy to deal with a broad range of shocks, the specification of the signs of the optimal Φy and Φp are ambiguous unless some assumptions are made about the values of the parameters. However, when the financial constraint on firms has a determinant effect on the supply of output,48 the effects of changes in the variance of the shocks on φp are similar to those obtained in the case of partial liberalization with no credit rationing.

V. Conclusions and Unresolved Issues

Our analysis indicates that the removal of capital controls and liberalization of the economy affects exchange rate policy both by broadening the set of shocks affecting the economy and by altering the nature of the impact of a given shock on domestic output and prices. For example, shocks to international interest rates would have an increasingly important effect on the economy (and therefore on the formulation of exchange rate policy) as domestic borrowers and depositors can more freely engage in external financial transactions. While the optimal scale of exchange market intervention can vary with the nature of the economy’s financial structure, there is nonetheless a similarity in the response of the optimal degree of intervention to increases in the variance of the various domestic and foreign shocks across all financial structures, as long as the authorities’ basic price or output stability objective remains unchanged. At the most fundamental level, these similarities reflect the influence of the financial constraint facing firms that they must finance their working capital needs prior to the sale of their output. This creates real and financial sector linkages that determine the economy’s response to the various domestic and real shocks. While changes in the economy’s capital controls and domestic financial regulations can amplify (or reduce) the effects of a given shock on prices or output, the financial constraint ensures that the nature of that impact (that is, whether it is positive or negative) is stable across financial structures.

In addition, our analysis indicates that the combination of domestic financial liberalization and the removal of capital controls would not in general create a preference for one particular type of exchange rate arrangement. The optimal change in exchange rate arrangements would reflect both the changes in the financial structure of the economy as liberalization takes place and the relative sizes of the various shocks that impinge on the economy.

Finally, our analysis indicates that the extent of the changes in optimal exchange rate arrangements that would occur as financial liberalization takes place would be strongly influenced by the nature of the terms and conditions under which domestic borrowers can access international financial markets. These terms and conditions would reflect both the nature of the country’s capital controls and decisions of international lenders regarding creditworthiness of domestic borrowers. As noted earlier, creditworthiness considerations influence both the interest cost of obtaining external credits and the availability of those credits if lenders become sufficiently concerned about the likelihood of default. As liberalization proceeds, creditworthiness considerations therefore replace official restrictions as the key limitation on market access. This also implies that shifts in market perceptions of the creditworthiness of a country’s borrowers could imply a sharp change in the nature of a country’s optimal exchange rate arrangements, especially if such shifts lead to the imposition of credit rationing.

There are a number of important issues that we have not been able to address in our analysis because of certain simplifying assumptions. Some of these have considerable policy relevance. For example, although we have assumed that the relationship between the stock of base money and the money supply would not be affected by the removal of capital controls or the domestic financial liberalization, this has clearly not been the case in most industrial countries. The money multiplier and the velocity of money have often been influenced by the removal of interest rate ceilings and the availability of new financial instruments. In addition, we have not allowed for the feedback effects between countries at different stages of domestic financial liberalization and employing different degrees of capital controls. Such feedback effects could be particularly important for countries on the periphery of the European Community, especially as 1992 approaches. Our analysis has also abstracted from the role of securities and equity markets. While incorporating the influence of these markets is clearly important, the requirement that firms fund their working capital needs (from whatever financial source) prior to production would ensure the existence of strong real and financial sector linkages no matter how complex the financial structure. Finally, we have ignored the effect of different types of fiscal systems on capital flows and the location of financial and real activity. Examining the effects of these factors on the relationship between financial structure and exchange rate policy leaves considerable scope for future work.

Comment

Giorgio Basevi

The distinguishing characteristic of the paper by Mathieson and Rojas-Suarez, and its main virtue, lie in its attempt to cast the analysis of optimal exchange markets regime within the structure of an economy subject to regulations of domestic financial markets, to controls of capital movements, and to credit rationing by international banks (when the economy opens up to their loans). Thus, the paper reexamines the conclusions previously reached in the literature on optimal exchange market regimes to make them more relevant to economies that gradually reduce and finally eliminate barriers to the integration of their money and financial markets with international markets.

From this perspective, the paper is a guide for future research addressed to actual countries and their historical or prospective developments. The paper’s theoretical structure—in particular its small-country assumption in both product and financial markets—suggests a possible application to peripheral countries that envisage deregulating and opening their financial markets. The model could be extended to analyze the consequences this may have for the costs and benefits of joining monetary systems, such as the European Monetary System (EMS), where the scope for exchange rate management would be greatly reduced or wholly eliminated.

In light of this purpose and the possible applications of the paper, the authors too readily select one among the possible avenues of research. This reduces the relevance of their analysis and conclusions to a case that is not necessarily the most interesting. This is to say that when we start considering an economy that is financially isolated from the rest of the world, we should consider its possible moves toward financial integration as involving a whole range of instruments and institutional features. With reference to the simplified model of the paper, the question of optimal management of economic policy has three dimensions:

  • (1) the optimal degree of international integration of the domestic credit market (which in the model implies selecting optimally the parameter θ in equation (7));

  • (2) the optimal degree of international integration of the domestic money market (which implies more than the zero-one choice offered by the authors between either imposing a ceiling on the domestic deposit rate or accepting enforcement of equation (10)); and

  • (3) the optimal exchange rate regime and exchange rate management (which implies selecting optimally the parameter ϕ in equation (6)).

All of these three dimensions correspond to different instruments of economic policy. Indeed, there is a fourth instrument in the model, that is, the choice of the required reserve ratio. Thus, the question of optimal economic policy should, in principle, involve all three (or four) dimensions. However, such an approach would greatly complicate the analysis. Moreover, there may be valid reasons for not considering all of these dimensions on the same grounds, that is, as policy instruments.

The strategy followed by the authors is to distinguish implicitly between (i) institutional rules, which are left outside their search for optimality; and (ii) policy instruments, which in their model are reduced to only one, that is, the exchange rate regime or the degree of exchange market intervention (parameter ϕ in equation (6)).

I argue that although the reduced set of instruments is justified for the sake of analytical simplicity and practical relevance, it is not necessarily the most appropriate with respect to the countries that the authors or readers may have in mind. The authors’ selection of the instruments to be gradually incorporated in the set of institutional rules, while leaving the degree of foreign exchange market intervention as the only instrument on which policy is finally optimized, is suggestive of a small country that for no reason—except the presumption of allocative efficiency but without reference to the theory of second best—decides gradually to dismantle controls on credit, on the domestic money market, and finally on all capital movements. In the end, this country is left out in the cold with its exchange rate regime, wondering whether to fix the exchange rate to some foreign currency or whether to float or manage it.

This situation may be applicable to large and economically autonomous countries, such as Japan, the Federal Republic of Germany, or, for other reasons, the United Kingdom. However, when we consider the actual or prospective experience of countries—such as those in the European Community and the EMS that are proceeding further with economic and monetary integration—the partition of policy instruments, as between institutionally-set rules and actually managed instruments, may be radically changed. In those countries’ experience, the choice of the exchange regime would in fact become an institutional rule, the selection of which may go beyond the economic optimality considerations of the type analyzed in the literature to which the authors refer. The question, at least for a country that considers joining a monetary union or even a looser system such as the EMS in its present form, would rather be whether the exchange rate fixity implied by joining the system may be better supported by keeping or dismantling regulations of monetary and credit markets and controls on capital movements.

The authors may counterargue that the move toward European monetary unification seems to have first followed the path of eliminating regulations and controls on money and financial markets, in order to later move toward full exchange rate fixity. However, it remains an open question—at least from the point of view of economic efficiency and the likelihood that the whole EMS experiment will succeed—whether such a sequence of moves, in which the exchange rate instrument is left out as the last available one before the final stage of monetary union, is the most appropriate.

To conclude, I would like to ask whether the paper, and at least some of the literature to which it is linked, refers just to the issue of choosing the optimal exchange rate regime, or also to that of designing an optimal pattern of official intervention in the foreign exchange market. It seems to me that the structure of the analysis, where no treatment of expectations is developed except that prices will revert to their long-run steady state, and where no dynamics are involved in determining the intervention parameter, is apt to answer the question of whether there should be zero or infinite intervention (floating or fixed exchange rates), rather than optimal management of exchange markets.

The analysis of how the optimal intervention parameter depends upon changes in the variability of real and monetary shocks is here conducted as a comparative static analysis. It throws no light on how management of exchange rates should optimally be conducted in the face of speculation and changing expectations in a truly dynamic system.

I think this should be clarified, so as not to disillusion the reader for not finding in this paper what is not meant to be there, and yet to emphasize the important elements about optimal choice of regimes, that are there.

Appendix I Derivation of the Aggregate Supply Function

Assume that the production sector of the economy is composed of identical entrepreneurs who maximize the expected utility of their planned consumption over time. Assume that the entrepreneurs are risk neutral and, therefore, that their instantaneous level of utility (Ut) is linearly related to the level of their consumption. Thus,

with “a” representing the marginal utility of consumption.

Each entrepreneur owns a firm and produces a single homogeneous good (Y), using capital (K) and labor (L). We assume that the output produced by each firm is subject to a random shock (N). While all entrepreneurs are assumed to share and to know the distribution of the shocks, they do not know the actual value of the shocks that will hit their output during the current and future period. Assume that each firm’s output is given by the following linear homogenous production function (f):

and the random shock affecting each firm is log normally distributed over the range between −∞ and ∞ with zero mean, constant variance, and density function g(Nt).

It is assumed that entrepreneurs need to make wage payments to employees at the beginning of each period and to finance their wage bill by borrowing from the domestic sector. Those loans (B) are obtained at the borrowing rate rb and repaid at the end of the period when the firm sells its output. Thus, the entrepreneur faces the following constraint:

where Wt = wage rate in period t and

Pt = price of the domestic good in period t.

In addition to their demand for labor and consumption plans, the entrepreneur also formulates plans for investment (Kt+1Kt). For simplicity, it is assumed that capital does not depreciate over time and can be sold at the same price as that prevailing for current output. The entrepreneur’s budget constraint will be given by:

In formulating plans, the entrepreneur recognizes that some production shocks will leave the firm unable to service its debt obligation out of the proceeds from the sale of its output. Let Nt* denote the scale of the shock for which the firm’s entire output is just sufficient to meet its debt obligations, thus:

with Ct = Kt+1Kt = 0 at this point.

When a shock is more negative than Nt*, the firm is considered to be in a situation of “default” in which the entreprenuer “dies”—that is, his current and future consumption is zero. These random shocks have important implications for the behavior of the supply of output by firms. This is so because uncertainty about production outcomes leads to risk premia on loans to firms and, in some cases, to quantitative credit rationing. In what follows, an entrepreneur’s supply of output will be derived under two alternative assumptions: (a) at the prevailing interest rates, the firm is able to obtain its desired amount of bank loans; and (b) at the prevailing interest rates, the firm is credit-rationed in that its demand for real bank loans exceeds the actual supply.

No Credit Rationing

Letting V(t) represent the entrepreneur’s value function (indirect utility function), his optimization problem becomes

subject to the budget constraint given in equation (16), the production function given in (14), and the utility function given in (13); and where β is the discount factor and E is the expectations operator.

The first order conditions for a maximum imply that:

where Qt represents the firm’s probability of nondefault at time t, and is given by: Nt*g[Nt]dNt

Equation (19) implies that labor is hired up to the point where its marginal product equals the expected real wage adjusted for the cost of borrowing. Equation (20) represents the optimal intertemporal allocation of consumption and equates the ratio of current to future discounted marginal utilities of consumption to the expected marginal return (in terms of goods) from investment. Equation (21) states that the entrepreneur’s consumption must satisfy his budget constraint.

Total differentiation of equation (20) and an updated (to period t+1) version of (19), lead to the following two-equation system:

The determinant of the coefficient matrix (A) will equal

In a nonstochastic environment with diminishing returns, the term in square brackets is negative. However, in a stochastic environment, the second term would be positive. Since the probability of Nt+1* occuring is typically much smaller than the probability of nondefault, it is assumed that Δ < 0 (which would be true in a nonstochastic environment). This will yield the firm’s implicit demands for capital and labor as:

with δΩ/δ(1+E(rb,t+1))<0;δΩδ(Wt+1/Pt+1)<0

with δ1/δ(1+rb,t)<0;δ1δ(Wt/Pt)<0.

Equation (23) indicates that, if the entrepreneur expects that the loan rate or real wage will rise in period t+1, other things being equal, it will reduce its investment since it will be more costly to hire the labor needed to work with that capital in period t+ 1. Similarly, if the current loan rate or real wage increases, the firm will reduce its current demand for labor (equation (24)).

To proceed toward a solution for the short-run aggregate supply function, assume that the production function takes the following form :

Let us now focus on small deviations around the firm’s steady-state level of output such that the stock of capital in period t equals its steady-state value. Using bars over a variable to denote its steady-state value and lower cap letters (with the exception of the interest rates) to denote the natural-log value of a variable, we obtain:

with ξ=[K¯αL¯(1α)/{K¯αL¯(1α)+N¯}],

Since in the steady-state, n¯t= 0.

Using equation (24), equation (26) becomes:

Next, assume equilibrium in the labor market by equating the demand for labor (equation (24)) to the following classical supply of labor equation:

with δLtsδ(Wt/Pt)>0andδLtsδ(1+rm,t1+Eπt)>0,

where rm,t is the interest rate paid on holdings of bank deposits and t, is the expected rate of inflation.

Totally differentiating the equation representing equilibrium in the labor market and solving for d(WtPt), we obtain:

where A1=δ1δ(WtPt)δLsδ(WtPt)<0..

From equation (28) we postulate the following semi-log-linear version of the real wage rate equation:

with δ4, δ5 > 0.

Finally, substituting equation (29) into equation (26), we obtain the aggregate supply function under no credit rationing:

with μ, μ5 >0.

Credit Rationing

If the firm is confronted with credit rationing, the amount that it can borrow must equal the available supply of funds (Bts)

In this case, the firm’s optimization problem becomes

and λ is a Lagrange multiplier.

As the credit-rationing constraint is assumed to be binding, the demand for labor becomes

As a result, deviations of output from its steady-state position take the following form (in log form):

Once again, we equate the demand for labor function to the supply of labor function; totally differentiating the resulting equation and solving for d(WtPt) we obtain:

where A2=1+WtPtδLsδ(Wt/Pt)>1..

Therefore, we can postulate the following semi-log linear version of the real wage equation:

with δ 1 δ 2 > 0.

Finally, substituting equation (35) into equation (33), we obtain the aggregate supply function under credit rationing (in log form):

Appendix II Derivation of the Risk Premium Equation

As stated in Appendix I, the probability of nondefault (Qt) is given by:

where Nt*=(1+rb,t)(Wt/Pt)Ltft(Kt,Lt).(37).

Credit Rationing Case

Under credit rationing the demand for labor is given by:

As a result, totally differentiating equation (37) in the neighborhood of the steady state, that is, assuming dK = 0

However, from equation (35) of Appendix I we know that

Using equation (39), we can rewrite equation (38) as:

Based on equation (40), we postulate the following semi-log linear form for the risk premium (or probability of default): ρ = 1 - Q under credit rationing:

with γ1, γ2, γ3 > 0.

Noncredit Rationing Case

Under noncredit rationing, the demand for labor is given by:

As a result, totally differentiating equation (37), we obtain:

but, in this noncredit rationing case, the first-order condition of the firm’s maximization problem implies (see Appendix I):

Also from equation (29) of Appendix I, we know that:

Using equations (43) and (44), equation (42) can be rewritten as follows:

Based on equation (45), we postulate the following semi-log linear form for the risk premium (or probability of default under no credit rationing):

with γ5, γ6 > 0.

Appendix III Solutions for the Fully Controlled Capital-Market Economy and the Partially Liberalized Economy Facing Credit Rationing

These cases are represented by equations (1a), (2), (3), (4), (5), and (6), and by assuming that the deposit interest rate is fixed at levels determined by the monetary authorities. That is, rm, t = r¯m. In the case of fully controlled capital markets, two additional assumptions need to be added: (1) the value of ψ equals one since there is no foreign borrowing and, therefore, the supply of credit is fully accounted for by the monetary base; and (2) the loan deposit rate is also determined by the monetary authorities. That is, rbt = r¯b. This last assumption, however, makes no difference to the results because the loan rate is not an argument in the supply of output and in the money demand equations. Even in these cases, equilibrium in the money market is achieved because the exchange rate is allowed to adjust.

Minimizing the Variance of Output Around Its Steady-State Level

When the authorities’ objective function (Z1, t) is:

The φy that minimizes equation (47)49 is:

Minimizing the Variance of the Price Level

When the authorities’ objective function (Z2, t) takes the following form:

The φp that minimizes equation (49)49 is:

Appendix IV The Case of Partial Removal of International Capital Controls and Partial Liberalization of Domestic Interest Rates in an Economy with No Credit Rationing

This case is represented by equations (1b), (2), (3), (58), and (9b) of the main text and by the assumption that the domestic deposit rate is fixed by the monetary authorities.

Minimizing the Output Variance Around Its Steady-State Level

The ϕythat minimizes equation (11)in the main text is:49

where

and

Minimizing the Variance of the Price Level

The ϕp that minimizes equation (12)in the main text is:

where

and z6=1+η1γ5(1+η1+θ (1+η1))+μ4γ6(1+θ)+μ5(1γ5(1+θ)).

Appendix V The Case of Fully Liberalized Financial Markets in an Economy Facing Credit Rationing

This case is represented by equations (1a), (28), (9a), and (10) of the main text; and by the assumption that θ = 0.

Minimizing the Variance of the Price Level

The θP that minimizes equation (12) in the main text is:49

where

and

Appendix VI The Case of Fully Liberalized Financial Markets in an Economy with No Credit Rationing

This case is represented by equations (1b), (2), (3), (58), (9b), and (10) of the main text and by the assumption that θ = 0.

Minimizing the Variance of Output Around Its Steady-State value

The φy that minimizes equation (11) in the main text is:49

where

Minimizing the Variance of the Price Level

The φp that minimizes equation (12) is:

and φp*>0ifμ4>μ5+η1.

References

    AschauerDavid andJeremyGreenwood“A Further Exploration in the Theory of Exchange Rate Regimes”Journal of Political EconomyVol. 91 (Chicago: 1983) pp. 86875.

    BaseviGiorgio“Multilateral Exchange Rate Determination: A Model for the Analysis of the European Monetary System,”Université de Montréal Departement de Science Economique et Centre de Recherche en Dévéloppement Economique Cahier 8202 (1982).

    BenavieArthur“Achieving External and Internal Targets with Exchange Rate and Interest Rate Intervention,”Journal of International Money and FinanceVol. 2 (Guilford, England: 1983) pp. 7585.

    BhandariJagdeep S. (1985a) “Informational Regimes, Economic Disturbances, and Exchange Rate Management,”in Exchange Rate Management Under Uncertainty (Cambridge, Massachusetts: MIT Press1985) pp. 12653.

    BhandariJagdeep S. (1985b) “World Trade Patterns, Economic Disturbances, and Exchange Rate Management,”Journal of International Money and FinanceVol. 4 (Guilford, England: 1985) pp. 33160.

    BhandariJagdeep S. ((1985c) Exchange Rate Management Under Uncertainty (Cambridge, Massachusetts: MIT Press1985).

    BryantRalph C.International Financial Intermediation (Washington: The Brookings Institution1987).

    CalomirisCharlesWand andR. GlennHubbard“Price Flexibility, Credit Availability, and Economic Fluctuations: Evidence from the United States, 1894–1909,”Quarterly Journal of EconomicsVol. 54 (Cambridge, Massachusetts: 1989) pp. 42952.

    DanielBetty“Optimal Foreign Exchange Policy for a Small Open Economy,”Journal of International Money and FinanceVol. 4 (Guilford, England: 1985) pp. 52336.

    The Delors ReportReport on Economic and Monetary Union in the European Community (Luxembourg: European CommunityAugust1989).

    DooleyMichael andPeterIsard“Country Preferences, Currency Values and Policy Issues,”Journal of Policy Modeling No. 9 (New York: North-Holland1987) pp. 6582.

    DriskillRobert andStephen A.McCafferty“Exchange Market Intervention Under Rational Expectations with Imperfect Capital Substitutability,” in Exchange Rate Management Under Uncertaintyedited byJagdeep S.Bhandari (Cambridge, Massachusetts: MIT Press1985) pp. 8395.

    EatonJonathan“Optimal and Time Consistent Exchange Rate Management in an Overlapping-Generations Model,”Journal of International Money and FinanceVol. 4 (Guilford, England: 1985) pp. 83100.

    FloodRobert J. andRobert J.Hodrick“Central Bank Intervention in a Rational Open Economy: A Model with Asymmetric Information,”in Exchange Rate Management Under Uncertaintyedited byJagdeep S.Bhandari (Cambridge, Massachusetts: MIT Press1985) pp. 15485.

    Folkerts-LandauDavid andDonald J.Mathieson“Innovation, Institutional Changes, and Regulatory Response in International Financial Markets,”in Restructuring Banking and Financial Services in AmericaWilliam S.Haraf andRose MarieKushmeidereds.,American Enterprise Institute for Public Policy Research (Washington: AEI1988) pp. 392423.

    FrenkelJacob A. andJoshuaAizenman“Aspects of the Optimal Management of Exchange Rates,”Journal of International EconomicsVol. 13 (Amsterdam: North-Holland1982) pp. 23156.

    HarknessJon“Optimal Exchange Intervention for a Small Open Economy,”Journal of International Money and FinanceVol. 4 (Guilford, England: 1985) pp. 10112.

    HelpmanElhanan“Toward a Consistent Comparison of Alternative Exchange Rate Regimes,”Canadian Journal of EconomicsVol. 12 (Toronto: 1979) pp. 394409.

    HelpmanElhanan“An Exploration in the Theory of Exchange Rate Regimes,”Journal of Political EconomyVol. 89 (Chicago: 1981) pp. 865901.

    HelpmanElhanan andAssafRazin“Exchange Rate Management: Intertemporal Tradeoffs,”American Economic ReviewVol. 77 (Nashville, Tennessee: 1987) pp. 10723.

    IsardPeterDonald J.Mathieson andLilianaRojas-Suárez“Financial Intermediation, Inflation, and Growth in Developing Countries”(unpublished,1989).

    Rojas-SuárezE. Liliana“Devaluation and Monetary Policy in Developing Countries: A General Equilibrium Model for Economies Facing Financial Constraints,”Staff PapersVol. 34 (Washington: International Monetary Fund1987) pp. 43970.

    StiglitzJ. andAndrewWeiss“Credit Rationing in Markets with Imperfect Information,”American Economic Review (Nashville, Tennessee: June1981) pp. 393410

    TurnovskyStephen J.“Optimal Exchange Market Intervention: Two Alternative Classes of Rules,”in Exchange Rate Management Under Uncertaintyedited byJagdeep S.Bhandari (Cambridge, Massachusetts: MIT Press1985) pp. 5572.

This paper benefits from comments by Giorgio Basevi, Morris Goldstein, Peter Isard, and Timothy Lane, although they are naturally not responsible for any remaining errors. The views presented here are those of the authors and do not necessarily represent those of the International Monetary Fund.

While it is generally accepted that optimal exchange rate arrangements depend on the policy objective function, the structural characteristics of the economy, and the relative importance of different types of shocks, this paper emphasizes that the degree of integration between domestic and external financial markets is an important structural characteristic in this context.

For an analysis of exchange rate determination in the EMS, see Basevi (1982).

For evidence on the effects of the availability of real credit on output in the United States, see (Calomiris and Hubbard 1989).

For simplification purposes, we take the authorities’ decision regarding the liberalization of domestic and external financial transactions as exogenous to our analysis of exchange rate policy. In a more general analysis, the sequencing of financial reforms and exchange rate policy would be determined simultaneously and would be designed to achieve the authorities’ overall efficiency and stability objectives. The model could be used, however, to analyze these issues given some assumptions about the authorities’ overall objective function.

More detailed analyses of these changes can be found in Bryant (1987) and Folkerts-Landau and Mathieson (1988).

Covered differentials may remain where different instruments are subject to different tax or regulatory considerations, or even where expected future tax rates differ (see Dooley and Isard, 1987).

See Stiglitz and Weiss (1981) for a further discussion.

This model is based on that developed in Isard, Mathieson, and Rojas-Suárez (1989). A similar model that abstracts from credit rationing is contained in Rojas-Suárez (1987).

If the firm’s revenue falls short of its debt obligations, the entrepreneur must transfer his capital to his creditors, and the firm ceases to exist.

This abstracts from the possibility that domestic banks might have reserves available to cover customer defaults or that the government might implicitly or explicitly guarantee the banks’ external debts.

Households are assumed to hold domestic money only in the form of bank deposits.

Our analysis also abstracts from the existence of curb markets, which often develop when interest rates are controlled.

All lower case letters, except those for interest rates, represent the log of the variable.

As noted earlier, firms may potentially face either disequilibrium or equilibrium credit rationing. In an economy closed to external financial transactions and where interest rate ceilings are set far below market-clearing levels, banks may not be able to attract the level of deposits that would allow them to create a stock of credit that equals the firms’ desired amount of credit at the ceiling loan rate. Such disequilibrium credit rationing would restrain domestic output by limiting the amount of labor that firms could hire. Alternatively, even if domestic banks have access to international financial markets, equilibrium credit rationing of firms could occur if the profit-maximizing decisions of international lenders led them to credit-ration domestic banks. Domestic banks would then, in turn, be forced to credit-ration domestic firms.

This is based on the “normal assumption” that the substitution effect of a higher expected real deposit rate on the households’ supply of labor services outweighs the income effect. See Isard, Mathieson, and Rojas-Suárez (1989) fora derivation of this labor supply function. When capital controls are totally removed, the households can hold foreign assets and the covered foreign interest rate would also affect labor supply decisions. However, since we have assumed that demand deposits and foreign assets are regarded as perfect substitutes in the households portfolio, the expected real return on deposits would be equal to the expected real return on foreign assets. Thus, the expected real return on deposits would serve as a proxy for the real return on both assets.

The nominal, rather than real, interest rate influences the desired level of borrowing because it is assumed that those working capital loans must be repaid within the period. Firms thus borrow from banks to meet wage payments at the beginning of the period (when labor and financial markets are open) and then repay at the end of the period, after they sell their goods. While the level of borrowing would naturally be affected by the price level expected to prevail at the end of the period, it would not be affected by the change in the price level between this period and the next.

This shock has an expected value of zero and a variance of σ2.

This shock has an expected value of zero and a variance of σv2.

This reserve ratio is not applied to any foreign borrowing by banks.

If the banks were risk-averse rather than risk-neutral, as assumed in our analysis, they might hold excess reserves. However, with risk neutrality, banks would only be concerned with expected profits that would be maximized by holding no excess reserves.

The balance sheets of the commercial banks imply: Bts=(1K)Mt+Ft, where Mt = stock of domestic deposits, Bts = stock of domestic credit, and Ft = foreign borrowing by domestic banks expressed in domestic currency. Equation (4) is obtained by taking logs of both sides of the above expression and taking a Taylor series expansion of the righthand side. ψ represents the proportion of domestic credit accounted for by (1 K)Mt. The value of Ft would depend on whether or not domestic banks are credit-rationed by international lenders. When there is credit rationing, Ft would be fixed by the lending decisions of international lenders. When there is no credit rationing, Ft would adjust to the value that would set Bts equal to the demand for loans (Btd) on the part of domestic firms (that is, Ft=Btd(1k)Mt).

The expected value of this random component is taken as zero, and its variance is given by (σg2).

Based on the “normal assumption” mentioned in the discussion of equations (1a) and (1b).

We are abstracting from the presence of deposit insurance guarantees.

Since the country faces given world prices of traded goods (apart from a random shock element), domestic aggregate demand (not specified) and the supply of domestic output (equations (1a) and (1b)) would combine to determine the level of the trade balance. In addition, the exogenous variables in our model are taken as constants (apart from any random shock elements) over time.

The simple stochastic process specified for the shocks (that is, all are distributed normally with zero mean and constant variance) and for the exogenous variables (that is, their expected value is assumed to be constant) greatly simplified the analysis. A more complete and realistic dynamic system could be obtained if we had allowed at least part of the shocks to have permanent effects. Such an extension of our work, however, remains as future research.

Earlier analyses of the specification of optimal exchange rate management in the presence of economic disturbances can be found in Benavie (1983), Bhandari (1985a), (1985b), (1985c), Daniel (1985), Driskill and McCafferty (1985), Eaton (1985), Flood and Hodrick (1985), Harkness (1985), Helpman and Razin (1987), and Turnovsky (1985).

In this case Ψ= 1 since no foreign borrowing is allowed. As a result, the changes in the domestic supply of credit reflect changes in the monetary base.

The derivation of the supply of output when all borrowers are credit-rationed is discussed in Appendix I.

Since all shocks in our model have an expected value of zero, the expected future price level (Ept + 1) is determined by only the nonstochastic elements in our model and would therefore be unaffected by any temporary money demand shock. As a result, the real return on deposit (r¯m-Et+1+pt) falls as pt declines since it would be expected that the price level would eventually rise to its long-run value.

As shown in Appendix III, Φv will be more likely to be positive as the variance of money demand shock rises relative to the variance of real output shocks.

The increase in the expected real returns on deposits occurs as the price level rises relative to the expected steady-state price level (which is unaffected by transitory shocks). This would raise output (see equation (1b)).

See, for example, Frenkel and Aizenman (1982).

When the objective is to stabilize consumption in the context of an exogenously determined output and zero capital mobility, flexible exchange rates are preferable in the presence of monetary shocks because the current account and, therefore, consumption remain unchanged. While our result would be similar to the traditional conclusion if μ1 > μ2 in the present case, our later analysis of a partially or fully liberalized economy that is not credit-rationed will show that our nontraditional conclusion holds even when the relative size of μ1 and μ2 are irrelevant.

As discussed earlier, such credit rationing would arise if international lenders took the view that the expected profit of an additional dollar of lending was zero or negative because such lending would increase the probability of default sufficiently to more than offset the higher interest income associated with the new loan. Since even with credit rationing some foreign credit could be made available to domestic borrowers, the total amount of credit available to borrowers in a partially open and liberalized economy would typically be larger than that in the closed economy considered in the previous section.

This would be strictly true only as long as any increase in international interest rates does not lower the domestic borrowers’ desired level of borrowing below the amount of credit made available by international lenders.

Even when domestic borrowers are not subject to equilibrium credit rationing, the interest rate paid on external borrowing would still be affected by creditworthiness considerations (equation (8)). As a result, the interest rate premium (relative to the risk-free international interest rate) that domestic borrowers would have to pay would rise as their level of borrowing increased relative to their steady-state level of borrowing.

This reflects the fact that, at the margin, changes in international interest rates would affect domestic borrowers’ excess demand for credit but would not alter the amount of external credit made available (which is constrained by credit rationing). As noted earlier, this assumes that the foreign interest rate does not reach a level where it drives the excess demand for credit to zero. It should be noted that the “equilibrium” credit rationing confronting domestic borrowers in this case differs from that evident in the closed financial system considered in the previous section. In the case of the closed economy, “disequilibrium” credit rationing arose because the authorities set ceilings that kept interest rates below their market-clearing levels. It would be possible in an economy with effective capital controls but a liberalized domestic financial system (that is, where interest rate ceilings were removed) that domestic borrowers might or might not be credit-rationed by domestic banks. See Isard, Mathieson, and Rojas-Suárez (1989) for an analysis of this situation. In the current case, however, credit rationing, if it exists, is an “equilibrium” phenomenon reflecting the desire of lenders not to become overexposed to a particular borrower (that is, not to lend beyond the point where the expected profit on the last dollar of lending is zero).

The appreciation would work to increase the loan rate and reduce the return to deposits, which would generate a lower level of output (equation (1b)). As the exchange rate appreciated, its value would decline relative to its expected steady-state level (Est+l,), which would create the expectation of a future exchange rate depreciation. This would raise the domestic loan rate relative to the international loan rate (equation (8)). In addition, the domestic price level would also decline (owing to the exchange rate appreciation) relative to its expected steady-state level (Ept+1), thereby creating the expectation of a future increase in prices. Such an expectation would reduce the expected return on deposits as long as r̄m remained constant.

When Φy>0, an increase in the variance of foreign price shocks would lead to a lower value of Φy This result is similar to that obtained in the fully controlled economy.

A positive money demand shock would generate an exchange rate appreciation that would lower the domestic price level. As noted earlier, the expected steady-state price level (Ept+1) would be unchanged by this transitory shock (since all shocks have an expected value of zero), and the lower initial price level would give rise to the expectation of a rise in the price level over time. Such inflation would reduce the real yield on deposits since r¯m is fixed.

As shown in Appendix IV, this is strictly true as long as the effect of the variance of interest rate shocks is small relative to the combined effects of the other variances.

As the exchange rate appreciates, its value would decline relative to the expected steady-state level of the exchange rate (Est+1), which is unaffected by transitory shocks. This expected future depreciation would widen the wedge between the domestic loan rate and the risk-free international interest rate (equation (8)).

The ω would also reflect the required reserve ratio.

In the case of a partially liberalized economy facing credit rationing, interest rate shocks did not influence Φp since the deposit rate was fixed by interest rate ceilings and the foreign loan rate did not represent the true shadow price of an additional dollar of credit. While it is still true that the loan rate does not represent the shadow price of credit (since there is credit rationing) in the present case, positive loan rate and deposit rate shocks would raise the domestic deposit rate, which would generate an excess demand for money and an appreciation of the exchange rate. To prevent or offset this exchange rate appreciation, the authorities would increase the stock of base money as the exchange rate appreciates. Moreover, as the variance of these interest rate shocks increases, so would the optimal degree of exchange market intervention.

See Appendix VI for the derivation of this result.

Our model would represent a “classical” economy where all transactions take place simultaneously and the real sector is insulated from the behavior of financial variables if μ4 = γ5 = 0(that is, the supply of output depended only on the real interest rate). A monetary shock would then affect the nominal domestic deposit rate and the exchange rate in opposite directions but in the same magnitude and as a result leave output unchanged independently of the exchange rate regime. The irrelevance of the exchange rate regime in a world where real variables are independent of the monetary sector is a well-known result (see Helpman, 1979 and 1981); but it has also been shown (see Aschauer and Greenwood, 1983) that the choice of exchange rate regimes is relevant when the financial sector impinges on the behavior of the real sector.

That is, when μ4>μ51 and that γ56 (see Appendix VI).

The full derivation of these results is available from the authors upon request.

    Other Resources Citing This Publication