Monetary Policy under Sudden Stops

Abstract

This paper proposes a model to investigate the effects of monetary policy in an emerging market economy that experiences a sudden stop of capital inflows. The model features credit frictions, debt denominated in foreign currency, imported inputs, and households that have access to the international capital market only indirectly, through their ownership of leveraged firms. The sudden stop is modeled as a change in the perceptions of foreign lenders that brings about an increase in the cost of borrowing. I show that the higher the elasticity of foreign demand, the lower the contraction in output-leading, at the extreme, to the possibility of an expansion, depending on policy. A second result is that the recession is most severe in a fixed exchange rate regime. Taylor rules that react to inflation and output are more stabilizing. A comparison of alternative rules shows that low commitment to inflation stabilization allows for less contraction in output and even expansion but at the cost of much stronger contraction in capital inflows and higher interest rates. Credibility is also shown to have an important role, with low credibility and the risk of loose policy implying increased trade-offs, stronger contraction of the economy, and higher interest rates.

Financial Intermediation and Credit Policy in Business Cycle Analysis

“…If a continuing bank has an additional net worth, it can save the cost of deposits and can increase assets by the leverage ratio t+1 ; where assets have an excess value equal to t+1 per unit). According to (21), the cost of deposits per unit to the bank t is the expected product of the augmented stochastic discount factor and the deposit rate R t+1 : Similarly from (22), the excess value of assets per unit, t , is the expected product of the augmented stochastic discount factor and the excess return R kt+1 R t+1 .…”

Fiscal and monetary policies and the cost of sudden stops

“…2 In contrast, Christiano et al (2004) conclude from their theoretical work that when there are frictions in adjustment in the traded goods sector, an expansionary monetary policy during a financial crisis might be welfare reducing. Similarly, Céspedes et al (2004) and Cúrdia (2007) look at exchange rate policy during currency crises and conclude that a flexible regime is Pareto superior. 3 Razin and Sadka (2004) offer an analysis of fiscal policy in a debt crisis and describe the conditions under which increasing the budget surplus might not help even if the original trigger for the crisis was government debt; while Mitra (2006) introduces an equivalent examination and concludes that the impact of fiscal policy on the growth outcome depends on the flexibility of production.…”

Financial crises and exchange rate policy

“…Contrary to this paper, their models focus on business cycle fluctuations and are not suited to study economies occasionally subject to financial crises. Christiano et al (2004), Cook (2004), Gertler et al (2007), Braggion et al (2007) and Curdia (2007) all use quantitative models to analyze the impact of monetary policy interventions during crisis times. In their frameworks crises are unexpected one-shot events, while this paper presents a model in which crises alternate with tranquil times and crisis probabilities are rationally anticipated by agents.…”