Financial Frictions and The Choice of Exchange Rate Regimes

This paper provides a quantitative assessment of the role of financial frictions in the choice

of exchange rate regimes. I use a two country model with sticky prices to compare different

exchange rate arrangements. I simulate the model without and with borrowing constraints

on investment, under monetary policy and technology shocks. I find that the stabilization

properties of floating exchange rate regimes in face of foreign shocks are enhanced relative to

fixed exchange rates in presence of credit frictions. In presence of symmetric and correlated

shocks fixed exchange rates regimes can perform better than floating. This analysis can have

important policy implications for accession countries joining the ERM II system and with high

degrees of credit frictions.