Exchange Rate Regimes, Location, and Specialization

This paper investigates the effects of fixed versus flexible exchange rates on firms’ location choices and on countries’ specialization patterns. In a two-country, two-differentiated-goods monetary model, uncertainty arises after wages are set and prices are optimally chosen. The paper shows that countries are more specialized under flexible than fixed rates, which indicates that the pattern of specialization is not uniquely defined by trade models but also depends on the exchange rate regime. The creation of a currency area endogenously increases the desirability of such an area by reducing the asymmetry of shocks across member countries. The results also shed light on the effects of exchange rate variability on trade.