International risk sharing and the choice of exchange-rate regime

This paper examines the argument that the fixed exchange-rate regime should be preferred to the flexible rate regime because the former allows risk sharing across countries while the latter does not. The analysis is performed in a two-country overlapping generations model, where markets are incomplete under all exchange regimes. It is shown that risks are pooled across countries when the equilibrium exchange rate is constant across states of nature, which arises under the fixed rate regime with or without capital restriction, and under the flexible rate regime without capital restriction. Risks are not pooled across countries when the equilibrium exchange rate is different across states of nature, which arises under the flexible rate regime with capital restriction. But in a model with incomplete markets, the ability to share risk across countries in the regimes with constant exchange rates does not necessarily lead to higher welfare than the inability to share risk in the regime with random exchange rates.