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Destabilizing Balance Sheet Effects in the New Consensus Model

Emiliano Libman ()

Eastern Economic Journal, 2019, vol. 45, issue 4, No 5, 590-611

Abstract: Abstract This paper proposes a simple modification of an otherwise standard New Consensus open economy model. We include an endogenous risk premium to show that a Taylor Rule that satisfies the Taylor Principle may lead to instability if exchange rate depreciations worsen the balance sheet of firms, exerting a negative effect on output and employment. Thus, the adoption of Inflation Targeting and a flexible exchange rate regime introduces destabilizing forces in economies that are exposed to liability dollarization, and this helps to rationalize central bank interventions in the foreign exchange market to avoid large exchange rate fluctuations.

Keywords: Inflation targeting; Balance sheet effects; Liability dollarization; Contractionary devaluations; Financial accelerator (search for similar items in EconPapers)
JEL-codes: E31 E52 E58 (search for similar items in EconPapers)
Date: 2019
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DOI: 10.1057/s41302-019-00146-3

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Handle: RePEc:pal:easeco:v:45:y:2019:i:4:d:10.1057_s41302-019-00146-3