Optimal exchange-rate policy under collateral constraints and wage rigidity

Abstract

This paper conducts a quantitative study of the optimal exchange-rate policy in a small open economy that faces the "credit access-unemployment" trade-off: In the presence of nominal wage rigidity, exchange-rate depreciation reduces unemployment; in the presence of collateral constraints linking external debt to the value of income, exchange-rate depreciation tightens the collateral constraint and leads to higher consumption adjustments. It is shown that the optimal policy during financial crises generally features large currency depreciation, since welfare costs related to higher unemployment and lower consumption typically outweigh welfare costs associated with intertemporal misallocation of consumption. The optimal policy also implies a lower currency depreciation than that necessary to achieve full employment, which is consistent with a managed-floating exchange-rate policy, frequently observed during financial crises in emerging market economies. Sudden stops (or large current-account adjustments) are part of the endogenous response to large negative shocks under the optimal exchange-rate policy.

Household heterogeneity and the transmission of foreign shocks

“…Here, we focus on the adverse effects of the exchange rate devaluation on the magnitude of the country's external liabilities, in a setting where these are denominated in foreign currency and where the supply of external credit does not depend on endogenous market prices. Ottonello (2013) addresses a related question in a setting where an exchange rate devaluation reduces a country's ability to borrow. Again, our key results differ from those in that paper, in that we find that a fixed exchange rate policy can deliver higher welfare than flexible exchange rate policies, due to its beneficial effect on the small open economy's terms of trade, a channel that is absent in that framework.…”

A Fisherian Approach to Financial Crises: Lessons from the Sudden Stops Literature

“…11 From a contractual point of view, the reason why non-tradable goods enter as collateral is that foreigners can seize them from a defaulting borrower and sell them in the domestic market in exchange for tradable goods. The literature has extensively used this formulation of the credit constraint in models of reserve accumulation (Durdu et al, 2009;Arce et al, 2019), macroprudential policy (Bianchi, 2011), real-exchange-rate stabilization policies (Benigno et al, 2013), ex-post intervention with industrial policy (Hernandez and Mendoza, 2017), self-fulfilling crises (Schmitt-Grohé and Uribe, 2018), noisy news and regime-switching shocks (Bianchi et al, 2016), trend shocks (Flemming et al, 2019;Seoane and Yurdagul, 2019), imperfect enforcement in capital-flow management policies (Bengui and Bianchi, 2018), models with banks intermediating capital inflows in T units to fund domestic loans in units of the domestic CPI (Mendoza and Rojas, 2019), and models of exchange-rate policy with nominal rigidities and credit frictions (Ottonello, 2015;Coulibaly, 2018;Farhi and Werning, 2016).…”

Capital Controls: A Survey of the New Literature

“…Similarly, Ottonello (2015), introduces pecuniary externalities arising from a collateral constraint defined on the real exchange rate, as in Benigno et al (2013), into the framework of Schmitt-Grohé and Uribe (2016a). In his model, during the crash, the exchange rate policy must trade-off relaxing the collateral constraint when it binds with containing unemployment.…”