Credit Rationing and Exchange-Rate Stabilization: Examining the Relation between Financial Frictions, Exchange-Rate Volatility, Lending Rates, and Capital Inflows

Gabriel Martínez

No 902, Working Papers from Ave Maria University, Department of Economics

Abstract: This paper develops and tests a model of the relation between the volatility of the exchange rate, default rates, the level of interest rates on loans, and the availability of credit, laying emphasis on frictions in the financial market, specifically foreclosure costs to collecting bad debts. On the assumption that foreign sources of funds are crucial for domestic finance, the paper tests the hypothesis of a high positive relation between the volatility of the exchange rate and the lending rate, and between the volatility of the exchange rate and capital inflows, on a sample of 54 countries over 1980-2000. The paper finds that exchange-rate and macroeconomic volatility are strong predictors of capital inflows (but not of lending rates) and that there may be an important role for financial frictions in the transmission process. Moreover, the paper finds that episodes of disinflation that rely on a reduction of the rate of depreciation tend to be accompanied by lower exchange rate volatility (in addition to simply lower rates of devaluation). Both effects, but principally the latter through financial frictions, suggest a solution to the lack of connection between the theory and the stylized facts of exchange rate-based stabilizations: ERBS programs may lead to initial booms through should cause a significant rise in the availability of credit, even if the cost of credit does not fall by much.

Keywords: interest rates; exchange rate volatility; financial frictions; creditor rights; exchange rate based stabilization (search for similar items in EconPapers)
JEL-codes: E31 E43 E44 E50 E63 F41 G14 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2009-08
New Economics Papers: this item is included in nep-ifn, nep-mac and nep-mon
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