Globalization, Exchange Rate Regimes and Financial Contagion

Abstract

Recent financial and economic crisis and, especially, crisis in the Euro zone, brought to the fore important issues concerning European and global financial infrastructure. Among them are: what is the proper level of financial integration and what are the optimal exchange rate arrangements between countries that are part of tightly knit financial networks. To make informed policy decisions in that regard, it is important to better understand how different levels of financial interconnectedness and different exchange rate regimes jointly influence stability of financial networks. This is the subject of our paper. We study fragility of financial networks operating in a multi-currency world in the context of a two-country multi-region connected network model a la Allen and Gale (Journal of Political Economy, 2000) with open-economy monetary features of Chang and Velasco (Journal of Economic Theory, 2000). We show that the effects of increased financial interconnectedness and different exchange rate regimes on financial stability should not be studied in isolation from one another. In particular, whether an increase in financial interconnectedness reduces or increases financial fragility depends, among other factors, on the exchange rate regime between countries. In addition, change in the exchange rate regime in one part of the network has very different repercussions on stability of the network depending on the degree of network interconnectedness. In particular, a switch from fixed to flexible exchange rate regime increases financial fragility of multi-currency networks under a complete system of financial links. On the other hand, an increase in financial interconnectedness reduces fragility under monetary union and fear of floating regime, but not necessarily under the flexible rate regime. To the best of our knowledge, this is the first theoretical contribution that analyzes joint impact of different degrees of network interconnectedness and exchange rate regimes on stability of multinational financial networks.