Financial market segmentation and choice of exchange rate regimes

- We study a small open economy model with segmented asset markets and financial sector shocks.
- We show analytically that the state-contingent optimal monetary policy facilitates risk sharing between participants and non-participants and is countercyclical.
- We compare welfare analytically across fixed and flexible exchange rate regimes.
- Flexible exchange regime mimics dynamics under optimal policy and welfare dominates the fixed regime.

We study the choice of exchange rate regime in a small open economy with segmented asset markets subjected to financial sector shocks. We show that the state-contingent optimal policy facilitates risk sharing between asset market participants and non-participants, and is countercyclical. Our results establish that contrary to existing literature, flexible exchange rates mimic optimal policy and welfare dominates fixed exchange rates.