Balance Sheets and Exchange Rate Policy

Luis Cespedes, Roberto Chang and Andres Velasco

No 7840, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We study the relation among exchange rates, balance sheets, and macroeconomic outcomes in a small open economy. Because liabilities are dollarized,' a real devaluation has detrimental effects on entreprenurial net worth, which in turn constrains investment due to financial frictions. But there is an offsetting effect, int hat devaluation expands home output and the return to domestic investment, which are also components of net worth. We show that the impact of an adverse foreign shock can be strongly magnified by the balance sheet effect of the associated real devaluation. But the fall in output employment, and investment is stronger under fixed exchange rates than under flexible rates. Hence the conventional wisdom, that flexible exchange rates are better absorbers of real foreign shocks than are fixed rates, holds in spite of potentially large balance sheet effects.

JEL-codes: F3 F4 (search for similar items in EconPapers)
Date: 2000-08
Note: IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (280)

Published as Cespedes, Luis Felipe, Roberto Chang and Andres Velasco. "Balance Sheets And Exchange Rate Policy," American Economic Review, 2004, v94(4,Sep), 1183-1193.

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