Financial crises and exchange rate policy

Fornaro, Luca

doi:10.1016/j.jinteco.2014.11.009

Cited by 65 publications

(45 citation statements)

References 56 publications

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“…When a crisis occurs, it should be possible to react to it (cf. for example Fornaro 2015). Therefore a too stable currency that cannot be adopted in any case is dangerous, while too much interference by politicians is also not in the interest of business companies.…”

Section: Growth-friendly Monetary Policymentioning

confidence: 99%

Which Currency is Best for Business in a Small Country?

Dilger

2015

SSRN Journal

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The optimal currency for a country is an important topic. While it is difficult to identify the best option overall, for all stakeholders and including political considerations, it is easier to answer the more limited question of the title: Which currency is best for business in a small country? Several kinds of currencies are discussed and three criteria that business companies are interested in are applied. Although there are opposing considerations, the best compromise for business in a small country seems to be a currency board with a fixed exchange rate that can be adapted in case of a crisis. A currency board is also the best protection against speculative attacks. The anchor currency should be that of the largest trading partner, especially if the trade with it is much larger than with all other ones.

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Section: Growth-friendly Monetary Policymentioning

confidence: 99%

Which Currency is Best for Business in a Small Country?

Dilger

2015

SSRN Journal

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“…3 One strand of the literature analyzes optimal monetary policy in small open economies with fixed exchange rates (Kollmann, 2002;Parrado and Velasco, 2002;Gali and Monacelli, 2005), while another deals with the choice of the exchange rate regime in the presence of nominal rigidities (Helpman and Razin, 1987;Bacchetta and van Wincoop, 2000;Devereux and Engel, 2003; Corsetti, Dedola, and Leduc, 2010;Schmitt-Grohé and Uribe, 2012; Bergin and Corsetti, 2015) or collateral constraints (Ottonello, 2015;Fornaro, 2015). 6 to this literature in two ways.…”

Section: Introductionmentioning

confidence: 99%

“…Surprisingly, we find that even in this frictionless world, the former ef- In this sense, our paper also relates to a growing literature that argues for a special role of the U.S. dollar in world financial markets. See for example Gourinchas and Rey (2007), Lustig et al (2011), Maggiori (2013), and Miranda-Agrippino and Rey (2015.3 One strand of the literature analyzes optimal monetary policy in small open economies with fixed exchange rates (Kollmann, 2002;Parrado and Velasco, 2002;Gali and Monacelli, 2005), while another deals with the choice of the exchange rate regime in the presence of nominal rigidities (Helpman and Razin, 1987;Bacchetta and van Wincoop, 2000;Devereux and Engel, 2003; Corsetti, Dedola, and Leduc, 2010;Schmitt-Grohé and Uribe, 2012; Bergin and Corsetti, 2015) or collateral constraints (Ottonello, 2015;Fornaro, 2015). 6 to this literature in two ways.…”

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confidence: 99%

A Risk-based Theory of Exchange Rate Stabilization

Hassan¹,

Mertens²,

Zhang³

2016

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We propose a novel, risk-based transmission mechanism for the effects of currency manipulation: policies that systematically induce a country's currency to appreciate in bad times lower its risk premium in international markets and, as a result, lower the country's risk-free interest rate and increase domestic capital accumulation and wages. Currency manipulations by large countries also have external effects on foreign interest rates and capital accumulation. Applying this logic to policies that lower the variance of the bilateral exchange rate relative to some target country ("currency stabilization"), we find that a small economy stabilizing its exchange rate relative to a large economy increases domestic capital accumulation and wages. The size of this effect increases with the size of the target economy, offering a potential explanation why the vast majority of currency stabilizations in the data are to the U.S. dollar, the currency of the largest economy in the world. A large economy (such as China) stabilizing its exchange rate relative to a larger economy (such as the U.S.) diverts capital accumulation from the target country to itself, increasing domestic wages, while decreasing wages in the target country. Differences in real interest rates across developed economies are large and persistent; some countries have lower real interest rates than others for decades rather than years. These longlasting differences in interest rates correlate with differences in capital-output ratios across countries, and account for the majority of excess returns on the carry trade, a trading strategy where international investors borrow in low interest rate currencies, such as the Japanese yen, and lend in high interest rate currencies, such as the New Zealand dollar ( Lustig, Roussanov, and Verdelhan, 2011; Hassan and Mano, 2015; Hassan, Mertens, and Zhang, 2015).A growing literature studying these "unconditional" differences in currency returns argues that they may be attributable to heterogeneity in the stochastic properties of exchange rates:Currencies with low interest rates pay lower returns because they tend to appreciate in bad times and depreciate in good times, providing a hedge to international investors and making them a safer investment (Lustig and Verdelhan, 2007;Menkhoff et al., 2013). This literature has explored various potential drivers of heterogeneity of the stochastic properties of countries' exchange rates, ranging from differences in country size (Martin, 2012;Hassan, 2013) and financial development (Maggiori, 2013) to trade centrality (Richmond, 2015) and differential resilience to disaster risk (Farhi and Gabaix, 2015). 1 The common theme across these papers is that whatever makes countries different from each other results in differential sensitivities of their exchange rates to various shocks, such that some currencies tend to appreciate systematically in "bad" states of the world (when the price of traded goods is high). Currencies with this property then pay lower expected returns a...

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“…A large literature studies the effects of nominal stabilizations in two-country New Keynesian models, where they affect the level of production by altering markups (e.g., Kollmann, 2002;Devereux and Engel, 2003;Fornaro, 2015). 4 Another, largely empirical, literature argues that stabilizations may promote bilateral trade or serve to import monetary policy credibility.…”

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confidence: 99%

A Risk-based Theory of Exchange Rate Stabilization

Hassan¹,

Mertens²,

Zhang³

2020

ERWP

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We develop a novel, risk-based theory of the effects of exchange rate stabilization. In our model, the choice of exchange rate regime allows policymakers to make their currency, and by extension, the firms in their country, a safer investment for international investors. Policies that induce a country's currency to appreciate when the marginal utility of international investors is high lower the required rate of return on the country's currency and increase the world-market value of domestic firms. Applying this logic to exchange rate stabilizations, we find a small economy stabilizing its bilateral exchange rate relative to a larger economy can increase domestic capital accumulation, domestic wages, and even its share in world wealth. In the absence of policy coordination, small countries optimally choose to stabilize their exchange rates relative to the currency of the largest economy in the world, which endogenously emerges as the world's “anchor currency.” Larger economies instead optimally choose to oat their exchange rates. The model therefore predicts an equilibrium pattern of exchange rate arrangements that is remarkably similar to the one in the data.

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Financial crises and exchange rate policy

Cited by 65 publications

References 56 publications

Which Currency is Best for Business in a Small Country?

Which Currency is Best for Business in a Small Country?

A Risk-based Theory of Exchange Rate Stabilization

A Risk-based Theory of Exchange Rate Stabilization

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