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Optimal Monetary Policy under Sudden Stops

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  • Vasco Curdia

    (Federal Reserve Bank of New York)

Abstract

Emerging market economies often face sudden stops in capital inflows or reduced access to the international capital market. This paper analyzes what should monetary policy do in such an event. Optimal monetary policy induces a hike in interest rate and exchange rate depreciation. The latter mitigates the impact of the sudden stop in the domestic economy by boosting export revenues. In spite of that, a recession is not avoided. It is shown in the paper that the arrival of the sudden stop further increases the problem of time inconsistency of policy. Optimal policy is fairly well approximated by a flexible targeting rule, in which a combination of domestic prices, exchange rate and output is stabilized. We show that whether a fixed exchange rate regime is a good policy strategy, from a welfare perspective, depends on the economic environment. For the benchmark parameterization, the peg is the worst of simple rules considered. For alternative parameterizations, featuring low nominal rigidities or high elasticity of foreign demand, the fixed exchange rate regime performs relatively better.

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  • Vasco Curdia, 2008. "Optimal Monetary Policy under Sudden Stops," 2008 Meeting Papers 474, Society for Economic Dynamics.
  • Handle: RePEc:red:sed008:474
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    Cited by:

    1. Cúrdia, Vasco & Woodford, Michael, 2016. "Credit Frictions and Optimal Monetary Policy," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 30-65.
    2. Andrea Ferrero & Mark Gertler & Lars E. O. Svensson, 2007. "Current Account Dynamics and Monetary Policy," NBER Chapters, in: International Dimensions of Monetary Policy, pages 199-244, National Bureau of Economic Research, Inc.
    3. Paul D. McNelis, 2014. "Finding Stability in a Time of Crisis: Lessons of East Asia for Eastern Europe," Working Papers 052014, Hong Kong Institute for Monetary Research.
    4. Gülçin Özkan & Ms. Filiz D Unsal, 2014. "On the use of Monetary and Macroprudential Policies for Small Open Economies," IMF Working Papers 2014/112, International Monetary Fund.
    5. J. Scott Davis & Kevin X. D. Huang, 2011. "Optimal monetary policy under financial sector risk," Globalization Institute Working Papers 85, Federal Reserve Bank of Dallas.
    6. Seong-Hoon Kim, 2012. "Sequential Action and Beliefs Under Partially Observable DSGE Environments," Computational Economics, Springer;Society for Computational Economics, vol. 40(3), pages 219-244, October.
    7. Paul Levine, 2012. "Monetary policy in an uncertain world: probability models and the design of robust monetary rules," Indian Growth and Development Review, Emerald Group Publishing Limited, vol. 5(1), pages 70-88, April.
    8. Gülçin Özkan & Ms. Filiz D Unsal, 2012. "Global Financial Crisis, Financial Contagion, and Emerging Markets," IMF Working Papers 2012/293, International Monetary Fund.
    9. Galo Nuño & Carlos Thomas, 2017. "Bank Leverage Cycles," American Economic Journal: Macroeconomics, American Economic Association, vol. 9(2), pages 32-72, April.
    10. Menelik Geremew, 2017. "Evaluating monetary policy with financial stability objective: rules vs. discretion," Applied Economics Letters, Taylor & Francis Journals, vol. 24(9), pages 602-617, May.
    11. Wen-Yao Grace Wang & Paula Hernandez-Verme & Raymond A. K. Cox Author E-mail: rcox@unbc.ca, 2012. "Financial Fragility, Exchange-Rate Regimes, and Sudden Stops in a Small Open Economy," Ekonomi-tek - International Economics Journal, Turkish Economic Association, vol. 1(3), pages 25-54, September.
    12. D. Filiz Unsal, 2013. "Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses," International Journal of Central Banking, International Journal of Central Banking, vol. 9(1), pages 233-285, March.
    13. Gulcin Ozkan & Filiz Unsal, "undated". "External finance, sudden stops and financial crisis: what is different this time?," Discussion Papers 09/22, Department of Economics, University of York.
    14. Mara Pirovano, 2013. "Household and firm leverage, capital flows and monetary policy in a small open economy," Working Paper Research 246, National Bank of Belgium.
    15. F. Gulcin Ozkan & D. Filiz Unsal, 2013. "On the use of monetary and macroprudential policies for financial stability in emerging markets," Discussion Papers 13/14, Department of Economics, University of York.
    16. Ferrari, Massimo, 2014. "The financial meltdown: a model with endogenous default probability," MPRA Paper 59419, University Library of Munich, Germany.

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