The choice between fixed and flexible exchange rates: Which is best for a small open economy?

The optimal exchange rate regime choice for a small open economy is investigated in a stochastic general equilibrium model. Even if the home money supply fluctuates heavily, pegging the exchange rate to a country with a less volatile monetary policy may not be welfare improving if prices are sticky in producer's currency. Owing to a reduction in the risk premium incorporated in prices output and thus work effort may rise so much that the positive welfare effect of an increase in overall consumption is overcompensated. This effect is stronger the closer the substitutability between home and foreign goods and the larger the tradable sector is. The model further implies that the policymaker can almost always reap a welfare gain by choosing an exchange rate peg if prices are set in the consumer's currency.