International financial integration, credit frictions and exchange rate regimes

This paper studies the stabilisation properties of different exchange rate policies in a small open economy with cross-border balance sheet interdependence. The model features price and wage rigidities, credit frictions à la Bernanke, Gertler and Gilchrist (1999) both between households and banks and between banks and entrepreneurs, as well as international fi?nancial linkages à la Ueda (2012). I fi?nd that, overall, the argument in favor of ?flexible exchange rates holds irrespectively of the degree of fi?nancial integration. In fact, for all shocks considered, a fi?xed exchange rate policy delivers larger output losses and higher volatility of real and fi?nancial variables. Furthermore, my results reveal that the cost of pegging the exchange rate is inversely related to the degree of fi?nancial integration. Finally, I fi?nd that the presence of fi?nancial linkages increases the trade-off between infl?ation and output volatility faced by the central bank of a small open economy.