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External Constraints on Monetary Policy and the Financial Accelerator

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Author Info
Mark Gertler
Simon Gilchrist
Fabio Natalucci

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Abstract

We develop a small open economy macroeconomic model where financial conditions influence aggregate behavior. We use this model to explore the connection between the exchange rate regime and financial distress. We show that fixed exchange rates exacerbate financial crises by tieing the hands of the monetary authorities. We then investigate the quantitative significance by first calibrating the model to Korean data and then showing that it does a reasonably good job of matching the Korean experience during its recent financial crisis. In particular, the model accounts well for the sharp increase in lending rates and the large drop in output, investment and productivity during the 1997-1998 episode. We then perform some counterfactual exercises to illustrate the quantitative significance of fixed versus floating rates both for macroeconomic performance and for welfare. Overall, these exercises imply that welfare losses following a financial crisis are significantly larger under fixed exchange rates relative to flexible exchange rates.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10128.

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Date of creation: Dec 2003
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Handle: RePEc:nbr:nberwo:10128

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Find related papers by JEL classification:
E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
F3 - International Economics - - International Finance

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