International financial markets' influence on the welfare performance of alternative exchange rate regimes

This paper assesses how the structure of international financial markets alters the welfare ranking of alternative exchange rate regimes in a small open economy. It is shown that financial market integration, i.e. moving from segmented towards complete financial markets, results in different monetary policy objectives, namely stabilizing domestic goods prices as opposed to stabilizing the nominal exchange rate. Thus, the welfare ranking of different exchange rate rules can change in the process of international financial integration. It becomes evident that no single exchange rate regime outperforms the others in stabilizing both domestic consumption and output variability in the process of financial market integration. Copyright 2010 Oxford University Press 2010 All rights reserved, Oxford University Press.