Paper #1431

Title:

Financial crises and exchange rate policy

Author:

Luca Fornaro

Date:

July 2014 (Revised: November 2014)

Abstract:

This paper studies exchange rate policy in a small open economy model featuring an occasionally binding collateral constraint and Fisherian deflation. The goal is to evaluate the performance of alternative exchange rate policies in sudden stop-prone economies. The key element of the analysis is a pecuniary externality arising from frictions in the international credit markets, which creates a trade-off between price and financial stability. The main result is that devaluing the exchange rate during a financial crisis has a positive impact on welfare, because the stimulus provided by a devaluation sustains asset prices, the value of collateral, and access to the international credit markets.

Keywords:

Financial crises, Monetary Policy, Sudden Stops, Exchange Rate Regime, Nominal Wage Rigidities, Pecuniary Externalities.

JEL codes:

G01, E44, E52, F32, F34, F41.

Area of Research:

Macroeconomics and International Economics

Published in:

Journal of International Economics, 95 (2), pp. 202-215, 2015

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