External Constraints on Monetary Policy and the Financial Accelerator

Abstract

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

Exchange Rates and Monetary Policy in Emerging Market Economies

“…2 While we focus on two types of shocks that hit emerging markets (interest rate shocks and terms of trade shocks), it turns out that our results regarding optimal monetary rules do not really depend on the source of shocks. In addition, echoing Céspedes et al (2002a,b) and Gertler et al (2001) in quite different settings, we find that external financing constraints have essentially no implications for the ranking of monetary rules. While balance sheet constraints in the presence of liability dollarisation is an important propagation channel, it essentially generates a magnification effect in response to all shocks, leading both real and financial volatility to be greater than in an economy without these constraints.…”

“…4 As in Schmitt-Grohé and Uribe (2003), these portfolio adjustment costs eliminate the unit root in the economy's net foreign assets. 5 We follow the majority of papers in this literature by assuming away any collateral constraints for consumer borrowing (BGG; Carlstrom and Fuerst, 1997;Gertler et al, 2001;Choi and Cook, 2004;Cook, 2004). Céspedes et al (2002a,b) by contrast assume that households have to consume their current earnings, without any access to capital markets.…”

Exchange Rate Policy and Sovereign Bond Spreads in Developing Countries

“…A further change from an intermediate one to a fixed one decreases the issuance probability by 4% and increases the spread by an additional 34 basis points. Our results, therefore, unambiguously point to the adverse effect of a fixed exchange rate regime on a country's foreign debt financing, which is consistent with the conclusions from Gertler, Gilchrist, and Natalucci ().…”

“…Moreover, by eliminating monetary policy as a viable policy instrument, hard pegs may force a government to increase its external liabilities, resulting in higher default risk. Gertler, Gilchrist, and Natalucci () show that fixed exchange rates exacerbate financial crises by tying the hands of the monetary authorities in a financial accelerator framework…”

“…Gertler, Gilchrist, and Natalucci () focus on the Korean experience during the 1997–98 financial crisis and quantitatively examine how defending an exchange rate peg may reinforce the financial crisis. Cespedes, Chang, and Velasco () also discuss the role of exchange rate regimes on excerbating financial crisis in a qualitative analysis.…”