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Financial Crises and Exchange Rate Policy

  • Luca Fornaro

    (London School of Economics)

This paper develops a dynamic small open economy model featuring an occasionally binding collateral constraint and nominal wage rigidities. The goal is to study the performance of alternative exchange rate policies in economies that endogenously alternate between tranquil times and crises. Financial frictions introduce a trade-off between price and financial stability. For low levels of foreign debt the probability of a future crisis is small and the best policy consists in targeting wage inflation. For high levels of foreign debt the probability of a future crisis is high and wage inflation targeting is dominated by a flexible exchange rate targeting rule, because the latter policy does a better job in mitigating the fall in output, consumption and capital inflows during crisis events. In contrast, pegging the exchange rate is always welfare dominated by targeting wage inflation. I also find that the exchange rate regime affects both the behavior of the economy during crisis events and the crisis probability, through its impact on debt accumulation during tranquil times.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 726.

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Date of creation: 2012
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Handle: RePEc:red:sed012:726
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