The growth effects of financial openness and exchange rates

•This paper highlights the role of financial openness when choosing an exchange rate regime.•Exchange rate flexibility can affect productivity growth.•High degree of financial openness reduces the negative effect of exchange rate volatility on growth.

This study examines the role of financial openness and international financial integration when choosing an exchange rate regime where the objective is to maximize productivity growth. The discussion begins with a simple generalization of a framework with credit constraints and concludes that the negative effects of exchange rate volatility on productivity growth are reduced the more financially integrated into the international capital flows a country is. Second, an empirical analysis of productivity growth provides thresholds and addresses potential endogeneity problems. Robust and significant results find that a high degree of financial openness can mitigate the negative effect of exchange rate flexibility on growth.