Exchange Rate Volatility and the Credit Channel in Emerging Markets: A Vertical Perspective

Ricardo Caballero () and Arvind Krishnamurthy

MPRA Paper from University Library of Munich, Germany

Abstract: Firms in emerging markets are exposed to severe financial frictions and credit constraints that are exacerbated by the sudden stop of capital inflows. Can monetary policy offset this external credit squeeze? We show that although this may be the case during moderate contractions (or in partial equilibrium), the expansionary effect of monetary policy vanishes during severe external crises. The exchange rate jumps to reduce the dollar value of domestic collateral until equilibrium in domestic financial markets is consistent with the external constraint. An expansionary monetary policy in this context raises the value of domestic collateral, but it exacerbates the exchange rate depreciation (beyond the standard interest parity effect) and has little effect on aggregate activity. However, there is a dynamic linkage between monetary policy and sudden stops. The anticipation of a dogged defense of the exchange rate worsens the consequences of sudden stops by distorting the private sector incentive to take precautions against these shocks. For similar general equilibrium reasons, dollarization of liabilities has limited impact during a sudden stop, but it has significant underinsurance consequences.

JEL-codes: G0 G00 (search for similar items in EconPapers)
Date: 2005-01-25
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

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Related works:
Journal Article: Exchange Rate Volatility and the Credit Channel in Emerging Markets: A Vertical Perspective (2005)
Working Paper: Exchange Rate Volatility and the Credit Channel in Emerging Markets: A Vertical Perspective (2004)
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:824

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