Masashige Hamano and Francesco Pappadà*

In a recent contribution, Maurice Obstfeld looks back at “The Case for Flexible Exchange Rates’’ made by Harry G. Johnson in 1969, and explores whether his argument survives the most recent academic critiques of exchange rate flexibility (1). He concludes that none of the arguments against exchange rate flexibility convincingly undermines the case for a flexible exchange rate. Nonetheless, policymakers have recently adopted exchange rate policies aimed at limiting the fluctuations of the exchange rate, as documented in Ilzetzki et al. (2019) (2).

In this article, Masashige Hamano and Francesco Pappadà provide a rationale for managed exchange rate policies that protect industries and workers in the export market from external economic shocks. They show that exchange rate movements may lead to fluctuations in the export market and higher uncertainty in the labor demand of exporter firms, providing a rationale for limiting the fluctuations in the nominal exchange rate. The authors examine the exchange rate policy trade-offs in a tractable framework where firm dynamics respond to external demand shocks under incomplete financial markets.

The main contribution of their article is to highlight the unexplored role of firm heterogeneity and nominal rigidities on the exchange rate policy trade-offs. In their economy, external demand shocks produce fluctuations in the nominal exchange rate that modify the selection of exporter firms. When firms are small on average and homogeneous in terms of productivity, the fluctuations on external demand may induce a larger fraction of firms to enter or exit the export market. In presence of wage rigidity, larger fluctuations in external demand translate in higher wage mark-ups. In this context, the optimal exchange rate policy responds to the external shocks, reducing the fluctuations of the nominal exchange rate and hence the uncertainty in the export market. The results therefore suggest that a managed exchange rate is welfare improving when firm heterogeneity is low, that is when many firms are subject to fluctuations in external demand. Instead, when firms are large on average and more heterogeneous, the benefits of dampened fluctuations in the exchange rate do not compensate for the costs associated with the high wage mark-ups of domestic firms. The optimal monetary policy therefore responds less to external demand shocks, letting the exchange rate free to float.

The authors remind us that the exchange rate policy trade-offs arise from the presence of incomplete financial markets, which distort the allocation under flexible prices. For this reason, a flexible exchange rate may not be efficient despite its ability to replicate the allocation of flexible prices. On the other hand, a fixed exchange rate may improve welfare by increasing the co-movement between the demand shock and the production of preferred goods, getting closer to the allocation of the social planner.

To conclude, the paper shows that the degree of firm heterogeneity determines the welfare ranking across different exchange rate policies. Importantly, this provides a novel rationale behind managed exchange rate policies: they may be preferred over a flexible exchange rate when firms are more homogeneous, as they reduce the uncertainty associated with the larger fluctuations in the export market.

(1) Obstfeld, Maurice, “Harry Johnson’s “case for flexible exchange rates” – 50 years later,” Working Paper Series WP20-12, Peterson Institute for International Economics, July 2020.
(2) Ilzetzki, Ethan, Carmen M Reinhart, and Kenneth S Rogoff, “Exchange Arrangements Entering the Twenty-First Century: Which Anchor will Hold?”, The Quarterly Journal of Economics, 2019, 134 (2), 599–646.

Original title of the article: Exchange rate policy and firm dynamics
Published in: Working Papers 2018, Waseda University, Faculty of Political Science and Economics, 2021. R&R at IMF Economic Review.
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* PSE Researcher

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