Trade and Welfare Under Alternative ExchangeRate Regimes

This paper compares the welfare under two standard alternative exchange rate regimes, fixed andflexible, in a stochastic dynamic general equilibrium two-country setting. Conventional wisdomholds that countries often prefer low exchange-rate variability to stabilize trade. This may explainthe observed ‘fear of floating’ in emerging markets — although most of them claim to adopt a flexiblesystem, in reality they often intervene to peg. We show that under incomplete capital markets afixed exchange rate regime unambiguously increases trade and improves welfare. This provides apotential explanation for the observed exchange rate policies in emerging markets.[...]