An Analysis of the Welfare Implications of Alternative Exchange Rate Regimes: An Intertemporal Model with an Application

Abstract

We construct a two-period model of an open economy and use the model to analyze the welfare implications of fixed and floating exchange regimes. Consumers have perfect foresight and save by holding domestic and foreign bonds, which are chosen according to relative interest rates, deflated by the rate of devaluation of the domestic currency. The government produces a pure public good and finances its deficits by issuing money, domestic bonds, and by foreign borrowing. The government's bonds compete with private investment, which is entirely debt financed. Foreign exchange, i.e., foreign bonds, is made available via the current account, endogenous private borrowing, and exogenous public borrowing. The government, in turn, acts as a passive auctioneer, trading foreign currency at market prices, and the exchange rate is defined as the domestic price of foreign bonds.The parameters of the model are estimated for Australia, and two counterfactual simulations have been carried out. In the first of these, a fixed exchange regime has been imposed upon 1983-84, when the exchange rate was actually allowed to float. Assuming that all exogenous parameters remain constant, the welfare implications of the two regimes are compared. The floating regime is found to be welfare superior for both categories of domestic consumers. Similar results are derived in a simulation in which the floating regime is imposed upon 1981-82, when a fixed exchange regime was actually in place. Our initial conclusion would be that, from the point of view of consumer welfare, floating exchange rates are superior to fixed rates in this Australian case.