Exchange Rate Policy and Heterogeneity in Small Open Economies

Abstract

I study the role of exchange rate regimes in shaping the distributional effects of external monetary shocks in a small open economy with two types of heterogeneity: in wealth and exposure to international trade. Under capital mobility, foreign tightening induces a combination of domestic tightening and currency depreciation, affecting consumption through the interest rate and income channels. Exchange rate policy determines their relative strength. Raising the interest rate under peg causes a recession and exacerbates inequality because the collapse in wages disproportionately affects the poor. The non-tradable sector is hit harder, being more sensitive to domestic demand. The consumption gap between tradable and non-tradable sectors opens wider in the left tail since it is driven by the divergence in wages. Letting the currency float boosts incomes through expenditure switching, while better interest rate insulation protects domestic demand, so the impact is more even across sectors and inequality decreases.