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Balance Sheets and Exchange Rate Policy

  • Luis Felipe Cespedes
  • Roberto Chang
  • Andres Velasco

We study the relation among exchange rates, balance sheets, and macroeconomic outcomes in a small open economy. Because liabilities are dollarized,' a real devaluation has detrimental effects on entreprenurial net worth, which in turn constrains investment due to financial frictions. But there is an offsetting effect, int hat devaluation expands home output and the return to domestic investment, which are also components of net worth. We show that the impact of an adverse foreign shock can be strongly magnified by the balance sheet effect of the associated real devaluation. But the fall in output employment, and investment is stronger under fixed exchange rates than under flexible rates. Hence the conventional wisdom, that flexible exchange rates are better absorbers of real foreign shocks than are fixed rates, holds in spite of potentially large balance sheet effects.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7840.

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Date of creation: Aug 2000
Date of revision:
Publication status: published as Cespedes, Luis Felipe, Roberto Chang and Andres Velasco. "Balance Sheets And Exchange Rate Policy," American Economic Review, 2004, v94(4,Sep), 1183-1193.
Handle: RePEc:nbr:nberwo:7840
Note: IFM
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