EXCHANGE-RATE REGIMES AND ASSURANCE AGAINST CONSUMPTION RISK

This paper challenges the argument that fixed exchange rates are always prefered to flexible exchange rates on the grounds that they automatically allow risk sharing accross countries. In a frictionless choice theoretic model, we show that this result is only valid under capital restriction when real shocks are imperfectly correlated. Inversely, flexible exchange rates allow a higher welfare under free trade in international financial exchanges. In this case, die stabilization of the nominal exchange rate creates a perfect correlation between financial assets that limits the pooling opportunities offered to the private sector against consumption risk.