In developed economies, monetary policy is generally counter-cyclical. For instance, there is a widespread consensus that policy should be eased in a recession. By contrast, in the recent experience of emerging market economies, monetary policy has often been pro-cyclical, raising interest rates during a crisis, usually in order to defend the exchange rate. As an example, after the Asian-Russian crisis of 1997-98, interest rates fell in the US, Australia, Canada, and most other developed economies, while they rose in almost all emerging market economies (Edwards 2001). Related evidence from Calvo and Reinhart (2002) indicates that many emerging economies place a high weight on exchange rate stability, even in face of large macroeconomic shocks which in principle would call for exchange rate adjustment.
Why do we see such a contrast between the policy responses of developed economies and emerging markets? One explanation is market confidence. Many of these economies have a history of bad policy, so that in a crisis it is more important to raise interest rates to restore the confidence of international capital markets than to attempt to stabilize the domestic economy. But many economists (e.g. Krugman(1998), Stiglitz (2002)) have questioned this, arguing that tight monetary policies exacerbate the crisis rather than generating confidence.
An alternative explanation for the differences in policy is that emerging market economies are more financial vulnerable, and in the presence of a mismatch between domestic assets and foreign liabilities in balance sheets, an exchange rate depreciation may be more of a hindrance than a help.
Empirical evidence supports the view that financial vulnerability is an important constraint on macroeconomic policy in emerging markets (Goldstein, Kaminsky, and Reinhart (2000)). These countries can almost never issue external debt in their own currency, and weak domestic financial institutions mean that balance sheet effects are an important limitation on domestic production (Eichengreen and Hausmann (2003)).
A growing literature has developed models in which balance sheet constraints impinge upon the workings of monetary policy and exchange rates. Many of these papers treat financial vulnerability as a collateral constraint that limit firm’s investment or production financing. Due to foreign currency denominated debt, these collateral constraints are likely to be sensitive to movements in the exchange rate.
This paper develops a very simple model of monetary policy making in an open economy, in the presence of sometimes binding collateral constraints which are related to trade credit financing. The main contribution of the paper is to construct an optimal, welfare maximizing monetary policy rule which takes collateral constraints into account. We find that an optimal rule calls for a conventional monetary policy in normal times, for small shocks. In this case, the exchange rate acts as a shock absorber, and helps to stabilize the real economy in face of external shocks.
But in face of large negative shocks which cause collateral constraints to bind, the optimal rule requires a counter-cyclical policy response. This is because when collateral constraints bind, exchange rate adjustment may be de-stabilizing. We can therefore rationalize why monetary policy should be pro-cyclical during a crisis, within the context of a welfare-maximizing optimal monetary policy problem. The key reason to tighten monetary policy in face of a negative shock is that this policy relaxes the collateral constraints facing the economy. In general however, we find that monetary policy should not be so pro-cyclical as to actually undo the collateral constraints entirely.
The model can help to explain why some countries might prefer exchange rate stability, even in face of large external shocks, which in the absence of financial constraints, would require substantial movement in exchange rates. Somewhat paradoxically, it is precisely when shocks are large and financial constraints may be binding that exchange rate stability may be desirable. With smaller shocks, which allow for adjustment without hitting collateral constraints, a flexible exchange rate is better.
An important consideration in the comparison of exchange rate regimes is the stock of outstanding foreign currency debt. When this is high, increasing the chances that the collateral constraint will bind, a fixed exchange rate is more likely to dominate a (non-optimal) floating exchange rate rule. This accords closely with the empirical evidence in Devereux and Lane (2003b).
There are a substantial number of papers that have explored different aspects of monetary policy in the presence of financial constraints . Two sets of papers that are close in spirit to ours are Cook (2002) and Choi and Cook (2002), and Christiano, Gust and Roldos (2002), and Braggion, Christiano and Roldos (2003). Cook (2002) shows that a negative balance sheet effect of a devaluation can be enough to cause a fall in output when investment borrowing is limited by domestic firms net worth. Choi and Cook (2002) extend this model to allow for the role of banks, and show that a fixed exchange rate can enhance welfare by stabilizing banks balance sheets. Christiano, Gust and Roldos (2002) introduce collateral constraints in financing trade credit, as we do, and show that monetary policy may be contractionary with binding collateral constraints. Braggion, Christiano and Roldos (2003) compute an optimal interest rate rule as a response to a financial crisis.
Our paper differs from these in a number of dimensions. First, it is extremely simple. The assumption that trade credit financing determines the form of the collateral constraint allows us to represent the economy in a one-period environment, which may be illustrated in a single diagram. Secondly, due to this simple setup, we can compute welfare-maximizing monetary policy rules, with commitment, in a stochastic environment, using exactly the approach as used in the recent literature on optimal monetary policy in open economy models with nominal rigidities. Our model in fact nests a standard open economy sticky-wage environment, when collateral constraints are absent, or never binding. Thus, the analysis allows us to be precise about the nature and extent of differences in monetary policy stance between developed economies and financially vulnerable emerging market countries.
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