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Currency Crises and Monetary Policy in an Economy with Credit Constraints

  • Aghion, Philippe
  • Bacchetta, Philippe
  • Banerjee, Abhijit

This paper presents a simple model of currency crises, which is driven by the interplay between the credit constraints of private domestic firms and the existence of nominal price rigidities. The possibility of multiple equilibria, including a ‘currency crisis’ equilibrium with low output and a depreciated domestic currency, results from the following mechanism: if nominal prices are ‘sticky’, a currency depreciation leads to an increase in the foreign currency debt repayment obligations of firms, and thus to a fall in their profits; this reduces firms' borrowing capacity and therefore investment and output in a credit-constrained economy, which in turn reduces the demand for the domestic currency and leads to a depreciation. We examine the impact of various shocks, including productivity, fiscal, or expectational shocks. We then analyse the optimal monetary policy to prevent or solve currency crises. We also argue that currency crises can occur both under fixed and flexible exchange rate regimes as the primary source of crises is the deteriorating balance sheet of private firms.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2529.

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Date of creation: Aug 2000
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Handle: RePEc:cpr:ceprdp:2529
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  1. Peter M. Garber & Lars E.O. Svensson, 1994. "The Operation and Collapse of Fixed Exchange Rate Regimes," NBER Working Papers 4971, National Bureau of Economic Research, Inc.
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  5. Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 1999. "Capital Markets and the Instability of Open Economies," CEPR Discussion Papers 2083, C.E.P.R. Discussion Papers.
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  10. Bernanke, Ben & Gertler, Mark, 1995. "Inside the Black Box: The Credit Channel of Monetary Policy Transmission," Working Papers 95-15, C.V. Starr Center for Applied Economics, New York University.
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