Financial Exposure, Exchange Rate Regime and Fear of Floating

We construct a dynamic general equilibrium model of a small open economy where

domestic entrepreneurs face borrowing constraints and finance their investment projects

both in domestic and international capital markets. We parametrize the degree of financial

exposure as the fraction of borrowing expressed in foreign units of denomination,

and study its interaction with alternative exchange rate regimes. We find that a

regime of flexible exchange rates greatly amplifies, relative to fixed rates, the response

to domestic shocks. However, when financial exposure is high investment can fall and

financial conditions can worsen in response to favorable productivity shocks, due to

detrimental balance-sheets effects. Asset price volatility and overall financial instability

are found to be monotonically increasing in financial exposure. In response to a

rise in world interest rates, higher financial exposure greatly worsens the performance

of flexible exchange rates (relative to the case with no exposure), so that the acclaimed

insulating role of the latter (relative to fixed) barely applies to output and vanishes for

financial variables. In general, the higher the degree of financial exposure, the closer

the resemblance between flexible and fixed exchange rates, a result that provides a

theoretical background for a fear-of-floating argument.