Exchange Rate Regimes and Location

June 1, 1997

.Exchange Rate Regimes and Location.
by Luca Antonio Ricci

This paper investigates the effects of fixed versus flexible exchange rate
regimes on the location choices of firms and on the degree of specialization
of countries. In a two-country two-differentiated-goods monetary model, demand,
supply, and monetary (and exchange rate) shocks arise after wages are set and
prices are optimally chosen. When real demand or supply shocks occur, the
exchange rate performs an adjustment role for firms located in the country that
is more specialized in the goods produced by those firms, but the exchange rate
constitutes a factor of disturbance for the other firms. As firms choose ex
ante the location that offers higher expected profits for their industry, the
paper finds that countries are more specialized under flexible than fixed
exchange rates. Similar results hold for monetary shocks (and for exogenous
exchange rate shocks).

The paper has two major implications. First, the pattern of specialization
indicated by any trade model is not unique but depends also on the exchange
rate regime. Second, the adoption of a fixed exchange rate regime increases the
desirability of such a currency area, as it induces sectoral dispersion of
production and consequently reduces the asymmetry of shocks. Interesting
implications for the effects of exchange rate variability on trade are also
drawn in the paper.