Risk-based Theory of Exchange Rate Stabilization.

This article develops a novel, risk-based theory explaining the effects of exchange rate stabilization policies, focusing on how such policies influence currency risk premia, interest rates, and capital accumulation. It shows that small countries optimally stabilize their real exchange rates relative to larger economies—typically the largest economy in the world—thereby making their currencies safer investments for international investors, lowering their risk-free interest rates, increasing the world-market value of domestic firms, and boosting domestic capital and wages. Larger economies, by contrast, tend to float their exchange rates or adopt looser stabilizations due to higher implementation costs. The model rationalizes the empirical pattern of exchange rate regimes observed since the Bretton-Woods system’s collapse, including the dominant role of the US dollar as the "anchor currency," and highlights that such stabilizations can benefit both stabilizing and target countries, while imposing costs on other floating economies. Extensions incorporating nominal frictions, partial credibility, preference shocks, and financial market segmentation confirm the robustness of these findings.