Globalisation, Exchange Rate Regimes, and Financial Contagion


The crisis of the euro zone in 2010–2012 brought several important questions to the fore, including the question of the proper level of financial integration and the optimal exchange rate arrangements between countries that are part of tightly knit financial networks. Using a simple Diamond–Dybvig style theoretical model, we show that the effects of increased financial interconnectedness and different exchange rate regimes on financial stability should not be studied in isolation from one another. We demonstrate that a switch from a fixed to a flexible exchange rate regime in one country increases the financial fragility of multi- currency systems in a complete network of financial links but decreases fragility if the network of links is incomplete. On the other hand, an increase in financial interconnectedness reduces fragility under a fixed exchange rate regime but does not necessarily do so under a flexible exchange rate regime.