Abstract: We study the choice of exchange rate regime in a small open economy with segmented asset markets subjected to financial sector shocks. We show that the state-contingent optimal policy facilitates risk sharing between asset market participants and non-participants, and is countercyclical. Our results establish that contrary to existing literature, flexible exchange rates mimic optimal policy and welfare dominates fixed exchange rates.

Authors’ Name: Vipul Mathur & Chetan Subramanian

URL: http://www.sciencedirect.com/science/article/pii/S0165176516300647

Journal: Economics Letters

Volume, Issue, Page Numbers: Volume 142, May 2016, Pages 78–82