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Net Worth, Exchange Rates, and Monetary Policy: The Effects of a Devaluation in a Financially Fragile Environment

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  • Domenico Delli Gatti
  • Mauro Gallegati
  • Bruce C. Greenwald
  • Joseph E. Stiglitz

Abstract

In this paper we propose an Open Economy Financial Accelerator model along the lines of Greenwald-Stiglitz (1993) close in spirit but different in many respects from the one proposed by Greenwald (1998.) The first goal of the paper is to provide a taxonomy of the effects of a devaluation in this context. The direct (first round) effect on output, taking as given net worth and interest rate, is negative for domestic firms (due to the input cost effect) and positive for exporting firms (due to a positive foreign debt effect). The indirect (second round) wealth effect (on output through net worth, taking as given the interest rate) is uncertain, depending on the relative size of the domestic and exporting firms. There is also an indirect effect on output through the response of the domestic interest rate to a devaluation due to the risk premium effect. Due to the uncertainty on the sign of most of these effects, it is difficult to assess the overall impact of a devaluation. One cannot rule out, however, an economy-wide contractionary effect of a devaluation. If the devaluation affects negatively the net worth of domestic firms, the domestic interest rate may rise (due to the risk premium effect), exerting an additional contractionary impact on output. If, on top of that, the monetary authorities force a further increase of the interest rate in an effort to curb the exchange rate, the contractionary effect will be emphasized.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13244.

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Date of creation: Jul 2007
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Handle: RePEc:nbr:nberwo:13244

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  1. Charles T. Carlstrom & Timothy S. Fuerst, 1996. "Agency costs, net worth, and business fluctuations: a computable general equilibrium analysis," Working Paper 9602, Federal Reserve Bank of Cleveland.
  2. Bernanke, Ben & Gertler, Mark, 1990. "Financial Fragility and Economic Performance," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 105(1), pages 87-114, February.
  3. Greenwald, Bruce C & Stiglitz, Joseph E, 1993. "Financial Market Imperfections and Business Cycles," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 108(1), pages 77-114, February.
  4. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, American Economic Association, vol. 94(4), pages 1183-1193, September.
  5. Mark Gertler & Simon Gilchrist & Fabio Natalucci, 2001. "External constraints on monetary policy and the financial accelerator," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Mar.
  6. Hali Edison & Pongsak Luangaram & Marcus Miller, 1998. "Asset Bubbles, Domino Effects and 'Lifeboats': Elements of the East Asian Crisis," CSGR Working papers series 05/98, Centre for the Study of Globalisation and Regionalisation (CSGR), University of Warwick.
  7. Arvind Krishnamurthy & Ricardo J. Caballero, 1999. "Emerging Markets Crisis," IMF Working Papers 99/129, International Monetary Fund.
  8. Lawrence J. Christiano & Christopher Gust & Jorge Roldos, 2002. "Monetary policy in a financial crisis," Working Paper 0204, Federal Reserve Bank of Cleveland.
  9. Philippe AGHION & Philippe BACCHETTA & Abhijit BANERJEE, 1999. "A Simple Model of Monetary Policy and Currency Crises," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP), Université de Lausanne, Faculté des HEC, DEEP 9914, Université de Lausanne, Faculté des HEC, DEEP.
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Cited by:
  1. Aysun, Uluc, 2008. "Automatic stabilizer feature of fixed exchange rate regimes," Emerging Markets Review, Elsevier, Elsevier, vol. 9(4), pages 302-328, December.

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