Over the past fifteen years there has been a dramatic rise in the frequency of financial crises that have apparently led to significant contractions in economic activity. One feature of these crises, that pertains in particular to open economies, is the strong connection with a fixed exchange rate regime. In a study covering the 1970s through the 1990s, Kaminsky and Reinhart [18] document the strong correlation between domestic financial strains and currency crises. Put differently, countries in the position of having to defend an exchange rate peg were more likely to have suffered severe financial distress. The likely reason is straight forward: defending an exchange rate peg generally requires a central bank to adjust interest rates in a direction that reinforces the crisis. Moreover, this connection between external constraints on monetary policy and financial crises is not simply a post war phenomenon: During the Great Depression, as Eichengreen [13] and others have shown, countries that stayed on the gold standard suffered far more severe financial and economic distress than countries that left early.
In this paper we develop a small open economy macroeconomic model where financial conditions influence aggregate behavior. Our goal is to explore the connection between the exchange rate regime and financial distress. Specifically, we extend to the open economy the financial accelerator framework developed in Bernanke, Gertler and Gilchrist [4] (hereafter BGG). We then consider the behavior of the economy under fixed versus flexible exchange rates and, in the process, isolate the role of the financial accelerator.
Section 2 develops the model. The core is a new open economy macro model with money and nominal price rigidities (as in, e.g., Obstfeld and Rogoff [24]). The financial accelerator mechanism links the condition of borrower balance sheets to the terms of credit, and hence to the demand for capital. Via the impact on borrower balance sheets, the financial accelerator magnifies the effects of shocks to the economy. As in Kiyotaki and Moore [19] and BGG, unanticipated movements in asset prices provide the main source of variation in borrower balance sheets. As in BGG, a countercyclical monetary policy can potentially mitigate a financial crisis: easing of rates during a contraction, for example, helps stabilize asset price movements, and hence borrower balance sheets. External constraints on monetary policy, however, limit this stabilizing option.
Section 3 presents a number of quantitative policy experiments. Specifically we explore the response of the economy to several shocks under fixed versus floating exchange rate regimes. Under the former, the central bank adjusts the short term rate to satisfy the peg. Under the latter, it adjusts the short rate according to an open economy variant of a Taylor rule. We find that financial accelerator effects are much stronger under fixed exchange rates than under flexible rates. The exchange rate peg forces the central bank to adjust the interest rate in a way that magnifies the financial accelerator effect. Indeed, a significant fraction of the enhanced volatility of output under fixed rates is due to the financial accelerator.
a fixed rate regime may be desirable: In this environment devaluations weaken borrower balance sheets. We accordingly consider the impact of having foreign indexed debt. As expected, this modificaton does raise output volatility under flexibile rates. Consistent with Cespedes, Chang and Velasco [10] (CCV), we find that volatility remains greater under fixed rates. However, we obtain this result for somewhat different reasons, however. In CCV, domestic assets do not serve as collateral but certain restrictions on the physical environment (specifically the assumption that capital is fully depreciable) ensure that flexible rates dominate. In our framework, flexible rates with foreign indexed debt dominate only because domestic assets do serve as collateral and monetary policy is able to move asset prices in a way that stabilizes balance sheets. Under fixed rates, adverse domestic asset price movements more than offset any gain from insulating balance sheets from exchange rate movements. In the absence of this domestic asset price channel, fixed rates could in fact dominate when there is foreign indexed debt.
Finally, we consider a hybrid scenario that often occurs in practice: The exchange rate is initially fixed, but then the central bank eventually abandons the peg. Here we show that if the central bank unexpectedly delays the abandonment (in the wake of an adverse shock), then the contraction in output can be nearly as bad as under a pure peg. The unexpected delay produces unanticipated contractions in asset prices, which significantly weaken borrower balance sheets. Section 4 provides concluding remarks.
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