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Currency Crises and Monetary Policy in an Economy with Credit Constraints: The No Interest Parity Case

Author

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  • U. Michael Bergman

    (Department of Economics, University of Copenhagen)

  • Shakill Hassan

    (School of Economics, University of Cape Town)

Abstract

This paper revisits the currency crises model of Aghion, Bacchetta and Banerjee (2000, 2001, 2004), who show that if there exist nominal price rigidities and private sector credit constraints, and the credit multiplier depends on real interest rates, then the optimal monetary policy response to the threat of a currency crisis is restrictive. We demonstrate that this result is primarily due to the uncovered interest parity assumption. Assuming that the exchange rate is a martingale restores the case for expansionary reaction - even with foreign-currency debt in firms' balance sheets. The effect of lower interest rates on output can help restore the value of the currency due to increased money demand.

Suggested Citation

  • U. Michael Bergman & Shakill Hassan, 2008. "Currency Crises and Monetary Policy in an Economy with Credit Constraints: The No Interest Parity Case," EPRU Working Paper Series 08-01, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics.
    • Handle: RePEc:kud:epruwp:08-01
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    References listed on IDEAS

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    More about this item

    Keywords

    currency crises; foreign–currency debt; balance sheets; interest parity; monetary policy;
    All these keywords.

    JEL classification:

    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • F30 - International Economics - - International Finance - - - General
    • O11 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Macroeconomic Analyses of Economic Development

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