On the Benefits of Exchange Rate Flexibility under Endogenous Tradedness of Goods

Previous efforts to compare the costs and benefits of fixed versus flexible exchange rate regimes have ignored the fact that it takes significant resources and time to develop export markets, and they have not included an analysis of the firm-level decision to enter or exit export markets. This paper develops a dynamic stochastic general equilibrium model to analyze the effects of endogenous tradedness of goods on the welfare gains from exchange rate flexibility. The actual range of traded goods in our model depends on the producers who choose to enter and exit export markets taking into account trade costs and relative productivities. A novel feature of the model is that it takes both time and resources to develop export markets and as a consequence expenditure-switching effects can be slow and will depend on a host of factors such as country size, trading costs and the competitive environment that producers face. Interestingly, because the model integrates a model of trade into a monetary business cycle model with sticky prices and wages, it is possible to study the interaction of macro and structural policies. However, in this study we focus initially on how different levels of trading costs can affect the structure of the economy and result in welfare costs of excessive exchange rate volatility