Exchange Rate Regimes and LocationWP/97/69-EAWP/97/69 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. |