Does Exchange-Rate Stability Increase Trade and Welfare?
📄 Summarized from the full manuscript · Human-reviewed for faithfulness before publication
In brief
Does a stable exchange rate really mean more trade -- and does more trade mean higher welfare? Bacchetta and van Wincoop build a two-country pricing-to-market model and show neither link holds generally: trade is identical under fixed and floating rates when preferences are separable, and can go either way otherwise, while welfare depends on a different set of variables (the variance of consumption and leisure) and on exactly how a fixed rate is implemented. The paper gives explicit cases where trade is higher under one regime while welfare is higher under the other.
What this paper finds — and why it matters
This 2000 American Economic Review paper by Philippe Bacchetta and Eric van Wincoop builds a one-period, two-country monetary general-equilibrium model to ask whether exchange-rate stability really increases trade and welfare, as the 1990 EC report “One Market, One Money” and much subsequent policy discussion had assumed. In the model, monopolistically-competitive firms set prices one period in advance in the currency of the buyer (pricing-to-market), money enters through cash-in-advance constraints, and the only source of uncertainty in the benchmark version is unanticipated monetary shocks; the nominal exchange rate is pinned down by the ratio of the two countries’ money supplies. The paper’s first main result, Proposition 1, is that trade – measured as exports plus imports over GDP – is not systematically higher under a fixed exchange-rate regime: it is exactly the same under fixed and floating rates when consumption and leisure enter utility separably, higher under fixed rates when consumption and leisure are substitutes, and lower under fixed rates when they are complements, a result that is shown to hold regardless of the international asset-market structure (Proposition 2). The intuition is that trade is governed by the certainty-equivalent revenues and labor costs firms face selling into the home versus the foreign market, which are equalized under separable preferences because the exchange-rate-is-the-money-ratio relation makes expected sales revenue identical across markets. Welfare, by contrast, is governed by the variance (and, under nonseparable preferences, the covariance) of consumption and leisure – a different set of objects entirely – so the paper’s second main result (Propositions 3-4) is that the welfare ranking of fixed versus floating regimes depends on both preferences and on the precise monetary rules implemented under each regime (for example, whether a fixed rate is run as a cooperative or a one-sided peg), and that there is in general no systematic relationship between which regime has more trade and which regime has higher welfare – the paper works through several explicit examples in which the trade and welfare rankings point in opposite directions. Extending the model to productivity and government-spending shocks under a monetary rule that uses the exchange rate to stabilize domestic employment reverses the trade result (making trade systematically lower under a float) while leaving the welfare comparison ambiguous, reinforcing the paper’s central claim that the textbook presumption – exchange-rate stability leads to more trade, and therefore to higher welfare – does not follow from first principles.
Summary of a classic paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Questions & answers
Q1. What is the basic structure of the one-period monetary model, and how are prices set?
The world consists of Home and Foreign, each with households, monopolistically-competitive firms (a la Dixit-Stiglitz) producing differentiated goods on the intervals [0,1] and [1,2] respectively, and a government that issues money randomly; households hold money through cash-in-advance constraints and must use the seller’s currency (Sec. I, pp. 1095-1096). Firms set prices for both the home and foreign market one period in advance, before the realization of each country’s money supply, denominated in the currency of the market where the good is sold (pricing-to-market); under money-market clearing (Y=M), the nominal exchange rate is pinned down simply as S = M/M* (Sec. I.C, eq. 12, p. 1097).
Q2. What is Proposition 1, and what is the intuitive mechanism behind it?
“Trade is not necessarily higher under a fixed exchange-rate system than it is under a floating exchange-rate system. In the benchmark monetary model, trade is the same under the two exchange-rate regimes when utility is separable in consumption and leisure. Trade is higher under a fixed exchange-rate system when consumption and leisure are substitutes, but it is lower when they are complements” (Sec. II, Proposition 1, p. 1099). The mechanism (Sec. II, pp. 1098-1099) is that optimal prices can be written as a markup over the certainty equivalent of labor costs divided by the certainty equivalent of sales revenue (eq. 16); because M = SM*, certainty-equivalent revenue is identical in both markets regardless of the exchange-rate regime, so the entire trade result comes down to certainty-equivalent labor costs, which depend on how correlated the wage is with demand in each market – a correlation that is shaped by whether consumption and leisure are substitutes or complements.
Q3. How robust is Proposition 1 to the structure of international asset markets?
Proposition 2 shows the result is unaffected by introducing international trade in assets of any structure: once trade is redefined as the certainty equivalent of exports plus imports over the certainty equivalent of GDP (since goods trade itself becomes stochastic once assets are traded), the same function of relative prices from equation (13) still governs it, and Proposition 1 “still holds once international trade in assets is introduced, for any asset-market structure” (Sec. II, Proposition 2 and Appendix B, p. 1101). The paper notes this implies the exchange-rate regime matters even under complete financial markets with sticky prices, in contrast to the classic flexible-price results of Helpman (1981) and Lucas (1982), in which fixed and floating regimes are equivalent once markets are complete and prices flexible.
Q4. What do Propositions 3 and 4 say about welfare, and about the trade-welfare relationship?
Proposition 3: “Welfare is not necessarily higher under a fixed exchange-rate system than it is under a floating exchange-rate system. The exchange-rate system under which welfare is highest depends on (i) preferences and (ii) the precise monetary-policy rules followed under each exchange-rate system.” Proposition 4: “In general there is no one-to-one relationship between the relative level of trade and the welfare ordering of exchange-rate regimes” (Sec. III, pp. 1101-1102). The paper shows, for example, that with risk aversion over leisure and separable preferences, welfare is strictly higher under a float (because leisure is less volatile when domestic and foreign demand shocks are not perfectly correlated, as they are under a fixed rate) even though trade is identical across the two regimes under the same separable preferences (Sec. III.A, pp. 1101-1102) – a direct illustration that the trade and welfare rankings answer different questions.
Q5. What explicit numerical example shows trade and welfare pointing in opposite directions?
Using a CES utility specification with risk aversion n=5, substitution elasticity between goods m=5, and varying the elasticity between consumption and leisure epsilon, Figures 1 and 2 show that for epsilon=0.3 (weak substitutes), welfare is larger under a float while trade is larger under a fixed exchange rate (Sec. III.A, p. 1103) – directly instantiating Proposition 4’s claim that the two orderings can diverge.
Q6. How does the choice between a one-sided peg and a cooperative peg affect the welfare comparison, holding the fixed-rate regime itself constant?
Introducing unobservable money-demand (velocity) shocks, the paper compares a one-sided peg (where only the foreign central bank adjusts its money supply to maintain the fixed rate, while home policy is unchanged from the float) against a cooperative peg (where both countries jointly stabilize the average of their shocks as the degree of intervention k approaches infinity). Under a one-sided peg, welfare is higher under a float (matching the separable-preferences benchmark result); under a cooperative peg, by contrast, welfare is higher under the fixed rate than under a float, because the cooperative peg automatically stabilizes the idiosyncratic components of velocity shocks across the two countries (Sec. III.B, pp. 1103-1104). The paper stresses that this difference in welfare ranking arises purely from how the fixed-rate regime is implemented, and does not affect the level of trade at all, which depends only on the correlation between M and M*, not on their relative volatility.
Q7. What happens when the model is extended to include productivity shocks under a monetary rule that stabilizes domestic employment?
With a monetary rule of the form M = m + g(a-1) in which money responds to productivity shocks a with intensity g>0 so as to stabilize employment under a float, trade becomes systematically higher under the fixed exchange-rate system (reversing the equal-trade benchmark result), because the monetary policy under a float stabilizes domestic labor demand specifically, making it relatively more attractive for firms to sell in the home market and so lowering the measured volume of trade (Sec. IV, pp. 1104-1105). The welfare effect of this same policy, however, remains ambiguous, depending on the relative strength of risk aversion over consumption versus leisure, since the policy lowers the volatility of leisure but raises the volatility of consumption (Sec. IV, p. 1105). A government-spending-shock extension (detailed in a technical appendix available on request) yields qualitatively similar conclusions.
Q8. What does the paper conclude about the policy debate over exchange-rate volatility and trade?
The conclusion states three findings: first, that adopting a fixed exchange-rate system does not necessarily lead to more trade, and under separable preferences with only monetary shocks, trade is entirely unaffected by the exchange-rate system, “consistent with most evidence”; second, that both the trade and welfare comparisons depend crucially on how each regime is specifically implemented (for example, one-sided versus cooperative pegs, and the degree of monetary-policy flexibility used to respond to shocks under a float); and third, that more trade does not always correspond to higher welfare, since the certainty-equivalent determinants of trade and the variance/covariance determinants of welfare are genuinely different objects (Sec. V, pp. 1105-1106).
Key terms in this paper
Definitions below follow the paper's own usage.
- Pricing-to-market with cash-in-advance (certainty-equivalent pricing)
- The paper's model structure (Sec. I): monopolistically-competitive firms set prices one period in advance in the currency of the market where a good is sold, before money supplies (the only source of uncertainty in the benchmark model) are realized; the resulting optimal price (eq. 16) equals a constant markup times the certainty equivalent of labor costs divided by the certainty equivalent of sales revenue, where the certainty equivalent is computed using the consumption-based stochastic discount factor.
- No one-to-one trade-welfare relationship
- The paper's Proposition 4 and its supporting examples (Sec. III): because the level of trade is governed by the certainty-equivalent revenues and labor costs firms face in the home versus foreign market, while welfare is governed by the variance (and, under nonseparable preferences, covariance) of consumption and leisure, the exchange-rate regime that delivers more trade need not be the regime that delivers higher welfare -- the paper gives explicit parameterizations in which the two orderings point in opposite directions.
- One-sided versus cooperative peg
- The paper's distinction (Sec. III.B) between two ways of implementing a fixed exchange-rate regime facing unobservable money-demand shocks: under a one-sided peg only the foreign central bank adjusts policy to hold the rate fixed, leaving welfare lower than under a float (matching the separable-preferences benchmark); under a cooperative peg both central banks jointly stabilize the average of the two countries' shocks, which raises welfare above the float outcome by automatically absorbing idiosyncratic velocity shocks -- the same nominal exchange-rate target can therefore rank above or below a float in welfare purely depending on how it is operated.