Emerging economies are prone to crises triggered by external shocks. During these crises, should the central bank stabilize the currency or domestic interest rates? If the choice is outside the central bank's control, as in a currency board, are there good policy substitutes? We argue that these questions are best analyzed in a 'vertical' framework, where the supply of external funds faced by the country is inelastic during the crisis and monetary policy affects mostly the domestic cost of scarce international liquidity. This is in contrast to the standard 'horizontal' framework where supply is elastic at the (now higher) international interest rate. In this vertical view, raising domestic interest rates during a crisis has relatively limited output consequences, while not doing so causes a sharp exchange rate overshooting. This asymmetry naturally leads to the widely observed fear of floating. However, while this response is ex-post rationalizable, it has negative ex-ante consequences as it exacerbates the structurally insufficient private sector incentives to insure against crises. Ex-ante, optimal monetary policy is countercyclical, and increasingly so as financial development falls. The silver lining for countries with limited financial development that cannot (or should not) overcome this conservative-central-bank time inconsistency problem, is that since the main role of monetary policy in the vertical view is one of incentives, it can be substituted by ex-ante measures to induce the private sector to insure against crises.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
8428.
Length: Date of creation: Aug 2001 Date of revision: Handle: RePEc:nbr:nberwo:8428
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Find related papers by JEL classification: E0 - Macroeconomics and Monetary Economics - - General E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
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Ricardo Caballero & Arvind Krishnamurthy, 2001.
"Smoothing Sudden Stops,"
NBER Working Papers
8427, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
Other versions:
Guillermo A. Calvo & Carmen M. Reinhart, 2000.
"Fear of Floating,"
NBER Working Papers
7993, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
Other versions:
Reinhart, Carmen & Calvo, Guillermo, 2002.
"Fear of floating,"
MPRA Paper
14000, University Library of Munich, Germany.
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Cited by: (explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)
Ricardo Caballero & Arvind Krishnamurthy, 2001.
"Smoothing Sudden Stops,"
NBER Working Papers
8427, National Bureau of Economic Research, Inc.
[Downloadable!] (restricted)
Other versions: