The Benefit of Exchange Rate Flexibility, Trade Openness and Extensive Margin

The literature on optimum currency areas argues that in the presence of countryspecific real shocks, the cost of fixing exchange rates is decreasing in the degree of trade openness. This study uses a stochastic dynamic general equilibrium model of endogenous specialization to assess the benefit of exchange rate flexibility. The benefit of exchange rate flexibility consists of the benefit along the extensive margin through adjustment in the composition of trade, and the benefit along the intensive margin through adjustment in the relative prices. Openness is found to influence these two benefits differently. Thus, the model predicts a non-monotonic relationship between openness and the benefit of exchange rate flexibility.