Inflation, Growth and Exchange Rate Regimes in Small Open Economies

Summary

This paper compares the merits of alternative exchange rate regimes in small open economies where financial intermediaries perform a real allocative function, there are multiple reserve requirements, and credit market frictions may or may not cause credit rationing. Under floating exchange rates, raising domestic inflation can increase production if credit is rationed. However, there exist inflation thresholds: increasing inflation beyond the threshold level will reduce domestic output.

Endogenously arising volatility may arise independently of the exchange rate regime. Private information — with high rates of domestic inflation — increases the scope for indeterminacy and economic fluctuations.

I would like to thank Leonardo Auernheimer, Valerie Bencivenga, Gabriele Camera, Dean Corbae, Scott Freeman, Todd Keister, Beatrix Paal, and Maxwell Stinchcombe for very helpful comments and suggestions. Very special thanks are due to Bruce D. Smith. The paper also benefited from the discussions in the seminars in CIDE, the Federal Reserve Bank of Atlanta, the Federal Reserve Bank of Kansas City, Indiana University, ITAM, Purdue University, the Second Annual Missouri Economics Conference, Texas A&M, the University of Missouri, the University of Texas at Austin and, last but not least, the participants in the Symposium in Honor of Bruce D. Smith: Recent Developments in Money and Finance. I dedicate this paper to the memory of Bruce D. Smith, my mentor and best friend.