Optimal exchange rate regime in a two-sector economy

The present article deals with the issue of optimal degree of exchange rate flexibility. It departs from the current literature on the subject as it does not introduce nominal rigidities nor address the question of international monetary cooperation. Instead, the argument hinges on the economic structure of the economy. The existence of sectorial strategic interactions yields a welfare improving opportunity of coordination for monetary policy. Monetary policy can act as a weak-coordinating device by reducing the market power of the price setting agent. This is possible by linking the non-cooperative agents' decision to money supply (through a monetary rule). The smaller a sector, the larger its ability to set a high relative price without having to bear the bad consequences of it. As a result, the monetary rule must be more restrictive vis-à-vis small sectors. In a very open economy, that is, when the non-tradable sector is small, the monetary rule must mainly link a restrictive monetary policy to the relative price of the non-tradable sector. On the contrary, in a nearly closed economy where the tradable sector represents a small share of national production, a fixed exchange regime becomes more suitable since it allows to keep the relative price of the tradable sector under control by avoiding frequent currency depreciation. For intermediate degree of openness, a semi-flexible exchange rate regime is more suitable.