Financial Crises and Exchange Rate Policy

Luca Fornaro

No 726, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: This paper develops a dynamic small open economy model featuring an occasionally binding collateral constraint and nominal wage rigidities. The goal is to study the performance of alternative exchange rate policies in economies that endogenously alternate between tranquil times and crises. Financial frictions introduce a trade-off between price and financial stability. For low levels of foreign debt the probability of a future crisis is small and the best policy consists in targeting wage inflation. For high levels of foreign debt the probability of a future crisis is high and wage inflation targeting is dominated by a flexible exchange rate targeting rule, because the latter policy does a better job in mitigating the fall in output, consumption and capital inflows during crisis events. In contrast, pegging the exchange rate is always welfare dominated by targeting wage inflation. I also find that the exchange rate regime affects both the behavior of the economy during crisis events and the crisis probability, through its impact on debt accumulation during tranquil times.

Date: 2012
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mon and nep-opm
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Citations: View citations in EconPapers (3)

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Journal Article: Financial crises and exchange rate policy (2015)
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