Currency mismatch, openness and exchange rate regime choice

Abstract

The paper analyzes the choice of an exchange rate regime for a small open economy indebted in foreign-currency, incorporating the financial accelerator. Conventional wisdom suggests that floating regimes should insulate the economy from real shocks. I show that this result depends on the degree of openness of the economy and foreign-currency indebtedness and, in fact, does not hold for relatively closed economies. The transmission mechanism relies on non-linearities in the impact of unanticipated real price changes on the external finance premium in the spirit of Fisher (1933).Currency mismatch Liability dollarization Balance sheets Exchange rate regimes Openness Nominal rigidities