Monetary Policy in Economic Crises: A Simple Model of Policy with External Financial Constraints

Michael Devereux and Doris Poon

International Economic Journal, 2011, vol. 25, issue 4, 683-711

Abstract: The experience of economic crises in emerging market economies suggests that the operation of monetary policy in these economies is severely limited by the presence of financial constraints. This is seen in the tendency to follow contractionary monetary policy during crises, and the observation that these countries pursue much more stable exchange rates than do high income advanced economies, despite having a more volatile external environment. This paper analyzes the use of monetary policy in an open economy in which exchange rate sensitive collateral constraints may bind in some states of the world. The appeal of the model is that it allows for a complete analytical description of the effects of collateral constraints, and admits a full characterization of welfare-maximizing monetary policy rules. The model can explain two empirical features of emerging market monetary policy described above -- in particular, that optimal monetary policy may be pro-cyclical under binding collateral constraints, and an economy with large external shocks may favor a fixed exchange rate, even though flexible exchange rates are preferred when external shocks are smaller.

Date: 2011
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DOI: 10.1080/10168737.2011.636630

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