We develop a small open economy macroeconomic model where financial conditions influence aggregate behavior. We use this model to explore the connection between the exchange rate regime and financial distress. We show that fixed exchange rates exacerbate financial crises by tieing the hands of the monetary authorities. We then investigate the quantitative significance by first calibrating the model to Korean data and then showing that it does a reasonably good job of matching the Korean experience during its recent financial crisis. In particular, the model accounts well for the sharp increase in lending rates and the large drop in output, investment and productivity during the 1997-1998 episode. We then perform some counterfactual exercises to illustrate the quantitative significance of fixed versus floating rates both for macroeconomic performance and for welfare. Overall, these exercises imply that welfare losses following a financial crisis are significantly larger under fixed exchange rates relative to flexible exchange rates.JEL Classification: E5, F3, F4

economies, we analyze the behavior of medium-and long-term inflation expectations using Consensus Economics Inc. semiannual surveys of market forecasters, and we employ the methods of Stock (1991) and Hansen (1999) to obtain median-unbiased measures of persistence for total and core consumer price inflation (CPI). Finally, since the experience with IT in the emerging market economies (EMEs) is mainly limited to the past few years, our analysis of these economies follows an event-study approach similar to that of Bernanke et al. (1999). For the industrialized economies, our evidence indicates that IT has played a significant role in anchoring long-run inflation expectations. For the United States and the euro area, private-sector inflation forecasts (at horizons up to ten years) exhibit a highly significant correlation with a three-year moving average of lagged inflation. 3 In contrast, at the longest horizons this correlation is largely absent for the five IT countries, indicating that these countries' central banks have been quite successful in delinking expectations from realized inflation. 4 We also find that actual inflation exhibits markour analysis excludes Norway and Switzerland (which adopted explicit inflation targets in 2000 and 2001, respectively) as well as Finland and Spain (which moved from IT to euro area membership). See Dueker and Fisher (1996). 3 In related work, Gurkaynak, Sack, and Swanson (2003) find evidence that shifts in private-market perceptions about long-term inflation account for a substantial proportion of the degree to which U.S. longterm bond rates are highly sensitive to federal funds rate surprises. See also Bernanke and Kuttner (2003), Bonfim (2003), and Kozicki and Tinsley (2001a,b). 4 For results regarding the effects of IT on short-term inflation expectations, see Johnson (2002, 2003) and Gavin (2004).

We analyze a new panel data set that includes balance sheet information, measures of expected default risk, and credit spreads on publicly-traded debt for more than 900 firms over the period 1997Q1 through 2003Q3. We obtain precise time-specific estimates of the financial frictions parameter underlying the benchmark financial accelerator model of Bernanke, Gertler, and Gilchrist (1999) and clearly reject the null hypothesis of no credit market imperfections; furthermore, for the expansionary period through mid-2000, these estimates are quite similar to the calibrated values used in previous research. Finally, we find that financial market frictions exhibit strong cyclical pattern, with parameter estimates rising by a factor of two during the latest economic downturn before returning to pre-recession levels in 2003.