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Currency Crises and Monetary Policy in an Economy with Credit Constraints: The No Interest Parity Case

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Author Info
U. Michael Bergman (Department of Economics, University of Copenhagen)
Shakill Hassan (School of Economics, University of Cape Town)
Abstract

This paper revisits the currency crises model of Aghion, Bacchetta and Banerjee (2000, 2001, 2004), who show that if there exist nominal price rigidities and private sector credit constraints, and the credit multiplier depends on real interest rates, then the optimal monetary policy response to the threat of a currency crisis is restrictive. We demonstrate that this result is primarily due to the uncovered interest parity assumption. Assuming that the exchange rate is a martingale restores the case for expansionary reaction - even with foreign-currency debt in firms' balance sheets. The effect of lower interest rates on output can help restore the value of the currency due to increased money demand.

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Paper provided by Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics in its series EPRU Working Paper Series with number 08-01.

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Length: 18 pages
Date of creation: May 2008
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Handle: RePEc:kud:epruwp:08-01

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Keywords: currency crises foreign–currency debt balance sheets interest parity monetary policy

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Find related papers by JEL classification:
E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
F30 - International Economics - - International Finance - - - General
O11 - Economic Development, Technological Change, and Growth - - Economic Development - - - Macroeconomic Analyses of Economic Development

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    Other versions:
  2. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, vol. 4(3), pages 179-92, Summer. [Downloadable!] (restricted)
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  4. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February. [Downloadable!] (restricted)
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  8. Rangvid, Jesper, 2001. " Second Generation Models of Currency Crises," Journal of Economic Surveys, Blackwell Publishing, vol. 15(5), pages 613-46, December. [Downloadable!] (restricted)
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  12. Ortiz, Alberto & Pablo, Ottonello & Sturzenegger, Federico & Talvi, Ernesto, 2007. "Monetary and Fiscal Policies in a Sudden Stop: Is Tighter Brighter?," Working Paper Series rwp07-057, Harvard University, John F. Kennedy School of Government. [Downloadable!]
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  14. Jason Furman & Joseph E. Stiglitz, 1998. "Economic Crises: Evidence and Insights from East Asia," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(1998-2), pages 1-136. [Downloadable!]
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