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Currency Crises and Monetary Policy in an Economy with Credit Constraints: The Case for Low Interest Rates Restored

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  • Shakill Hassan

Abstract

This paper revisits the currency crises model of Aghion, Bacchetta and Banerjeee (2000, 2001, 2004), who show that if there exist nominal price rigidities and private sector credit constraints, and the credit multiplier depends on real interest rates, then the optimal monetary policy response to the threat of a currency crisis is restrictive. We demonstrate that this result is primarily due to the uncovered interest parity assumption. Assuming that the exchange rate is a martingale restores the case for expansionary reaction — even with foreign-currency debt in firms’ balance sheets. The effect of lower interest rates on output can help restore the value of the currency due to increased money demand..

Suggested Citation

  • Shakill Hassan, 2006. "Currency Crises and Monetary Policy in an Economy with Credit Constraints: The Case for Low Interest Rates Restored," Working Papers 44, Economic Research Southern Africa.
  • Handle: RePEc:rza:wpaper:44
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    File URL: http://www.econrsa.org/node/69
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    Keywords

    interest parity; monetary policy; foreign-currency debt; currency crises;

    JEL classification:

    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • F30 - International Economics - - International Finance - - - General
    • O11 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Macroeconomic Analyses of Economic Development

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