Currency Crises and Monetary Policy in Economies with Partial Dollarization of Liabilities

After the breakdown of aggregate investment observed after the 1997-98 East Asian crisis, in almost all countries which suffered from sharp nominal devaluations, academicians and policymakers have engaged in a hot debate about the adequate monetary policy strategy against a speculative attack on the domestic currency. By means of a simple currency crisis model based on Proa~no, Flaschel and Semmler (2005), this paper shows how an increase in the domestic interest rate by the central bank, as a response to a currency run on the domestic currency, can significantly affect the aggregate demand by depressing the investment of the subsector of domestic firms which are not indebted in foreign currency. Furthermore, it is shown that, in specific scenarios, the strategy adopted by the East Asian countries of domestic interest rate increases might not have been the best response to a speculative attack from the medium term point of view.