IDEAS home Printed from https://ideas.repec.org/p/red/sed008/474.html
   My bibliography  Save this paper

Optimal Monetary Policy under Sudden Stops

Author

Listed:
  • Vasco Curdia

    (Federal Reserve Bank of New York)

Abstract

Emerging market economies often face sudden stops in capital inflows or reduced access to the international capital market. This paper analyzes what should monetary policy do in such an event. Optimal monetary policy induces a hike in interest rate and exchange rate depreciation. The latter mitigates the impact of the sudden stop in the domestic economy by boosting export revenues. In spite of that, a recession is not avoided. It is shown in the paper that the arrival of the sudden stop further increases the problem of time inconsistency of policy. Optimal policy is fairly well approximated by a flexible targeting rule, in which a combination of domestic prices, exchange rate and output is stabilized. We show that whether a fixed exchange rate regime is a good policy strategy, from a welfare perspective, depends on the economic environment. For the benchmark parameterization, the peg is the worst of simple rules considered. For alternative parameterizations, featuring low nominal rigidities or high elasticity of foreign demand, the fixed exchange rate regime performs relatively better.

Suggested Citation

  • Vasco Curdia, 2008. "Optimal Monetary Policy under Sudden Stops," 2008 Meeting Papers 474, Society for Economic Dynamics.
  • Handle: RePEc:red:sed008:474
    as

    Download full text from publisher

    File URL: https://red-files-public.s3.amazonaws.com/meetpapers/2008/paper_474.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Arminio Fraga & Ilan Goldfajn & André Minella, 2004. "Inflation Targeting in Emerging Market Economies," NBER Chapters, in: NBER Macroeconomics Annual 2003, Volume 18, pages 365-416, National Bureau of Economic Research, Inc.
    2. Mark Gertler & Simon Gilchrist & Fabio M. Natalucci, 2007. "External Constraints on Monetary Policy and the Financial Accelerator," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(2‐3), pages 295-330, March.
    3. Michael B. Devereux & Philip R. Lane & Juanyi Xu, 2006. "Exchange Rates and Monetary Policy in Emerging Market Economies," Economic Journal, Royal Economic Society, vol. 116(511), pages 478-506, April.
    4. Frederic S Mishkin & Miguel A Savastano, 2002. "Monetary Policy Strategies For Emerging Market Countries: Lessons From Latin America," Comparative Economic Studies, Palgrave Macmillan;Association for Comparative Economic Studies, vol. 44(2-3), pages 45-82, September.
    5. Ricardo J. Caballero & Arvind Krishnamurthy, 2004. "Inflation Targeting and Sudden Stops," NBER Chapters, in: The Inflation-Targeting Debate, pages 423-442, National Bureau of Economic Research, Inc.
    6. Pierpaolo Benigno & Michael Woodford, 2007. "Optimal Inflation Targeting under Alternative Fiscal Regimes," Central Banking, Analysis, and Economic Policies Book Series, in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.),Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 3, pages 037-075, Central Bank of Chile.
    7. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
    8. Braggion, Fabio & Christiano, Lawrence J. & Roldos, Jorge, 2009. "Optimal monetary policy in a [`]sudden stop'," Journal of Monetary Economics, Elsevier, vol. 56(4), pages 582-595, May.
    9. David K. Backus & Bryan R. Routledge & Stanley E. Zin, 2005. "Exotic Preferences for Macroeconomists," NBER Chapters, in: NBER Macroeconomics Annual 2004, Volume 19, pages 319-414, National Bureau of Economic Research, Inc.
    10. Frederic S. Mishkin, 2000. "Inflation Targeting in Emerging-Market Countries," American Economic Review, American Economic Association, vol. 90(2), pages 105-109, May.
    11. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
    12. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
    13. Cook, David, 2004. "Monetary policy in emerging markets: Can liability dollarization explain contractionary devaluations?," Journal of Monetary Economics, Elsevier, vol. 51(6), pages 1155-1181, September.
    14. Benigno, Pierpaolo & Woodford, Michael, 2012. "Linear-quadratic approximation of optimal policy problems," Journal of Economic Theory, Elsevier, vol. 147(1), pages 1-42.
    15. John Hawkins, 2005. "Globalisation and monetary operations in emerging economies," BIS Papers chapters, in: Bank for International Settlements (ed.), Globalisation and monetary policy in emerging markets, volume 23, pages 59-80, Bank for International Settlements.
    16. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 277-316.
    17. Guillermo A. Calvo, 1998. "CAPITAL FLOWS AND CAPITAL-MARKET CRISES: The Simple Economics of Sudden Stops," Journal of Applied Economics, Taylor & Francis Journals, vol. 1(1), pages 35-54, November.
    18. Carmen M. Reinhart, 1995. "Devaluation, Relative Prices, and International Trade: Evidence from Developing Countries," IMF Staff Papers, Palgrave Macmillan, vol. 42(2), pages 290-312, June.
    19. Reinhart, Carmen & Calvo, Guillermo, 2000. "When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options," MPRA Paper 6982, University Library of Munich, Germany.
    20. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
    21. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-491, June.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Andrea Ferrero & Mark Gertler & Lars E. O. Svensson, 2007. "Current Account Dynamics and Monetary Policy," NBER Chapters, in: International Dimensions of Monetary Policy, pages 199-244, National Bureau of Economic Research, Inc.
    2. Paul D. McNelis, 2014. "Finding Stability in a Time of Crisis: Lessons of East Asia for Eastern Europe," Working Papers 052014, Hong Kong Institute for Monetary Research.
    3. Cúrdia, Vasco & Woodford, Michael, 2016. "Credit Frictions and Optimal Monetary Policy," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 30-65.
    4. Gülçin Özkan & Ms. Filiz D Unsal, 2014. "On the use of Monetary and Macroprudential Policies for Small Open Economies," IMF Working Papers 2014/112, International Monetary Fund.
    5. Gülçin Özkan & Ms. Filiz D Unsal, 2012. "Global Financial Crisis, Financial Contagion, and Emerging Markets," IMF Working Papers 2012/293, International Monetary Fund.
    6. Galo Nuño & Carlos Thomas, 2017. "Bank Leverage Cycles," American Economic Journal: Macroeconomics, American Economic Association, vol. 9(2), pages 32-72, April.
    7. Menelik Geremew, 2017. "Evaluating monetary policy with financial stability objective: rules vs. discretion," Applied Economics Letters, Taylor & Francis Journals, vol. 24(9), pages 602-617, May.
    8. Wen-Yao Grace Wang & Paula Hernandez-Verme & Raymond A. K. Cox Author E-mail: rcox@unbc.ca, 2012. "Financial Fragility, Exchange-Rate Regimes, and Sudden Stops in a Small Open Economy," Ekonomi-tek - International Economics Journal, Turkish Economic Association, vol. 1(3), pages 25-54, September.
    9. Gulcin Ozkan & Filiz Unsal, "undated". "External finance, sudden stops and financial crisis: what is different this time?," Discussion Papers 09/22, Department of Economics, University of York.
    10. Mara Pirovano, 2013. "Household and firm leverage, capital flows and monetary policy in a small open economy," Working Paper Research 246, National Bank of Belgium.
    11. Paul Levine, 2012. "Monetary policy in an uncertain world: probability models and the design of robust monetary rules," Indian Growth and Development Review, Emerald Group Publishing Limited, vol. 5(1), pages 70-88, April.
    12. D. Filiz Unsal, 2013. "Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses," International Journal of Central Banking, International Journal of Central Banking, vol. 9(1), pages 233-285, March.
    13. J. Scott Davis & Kevin X. D. Huang, 2011. "Optimal monetary policy under financial sector risk," Globalization Institute Working Papers 85, Federal Reserve Bank of Dallas.
    14. Seong-Hoon Kim, 2012. "Sequential Action and Beliefs Under Partially Observable DSGE Environments," Computational Economics, Springer;Society for Computational Economics, vol. 40(3), pages 219-244, October.
    15. F. Gulcin Ozkan & D. Filiz Unsal, 2013. "On the use of monetary and macroprudential policies for financial stability in emerging markets," Discussion Papers 13/14, Department of Economics, University of York.
    16. Ferrari, Massimo, 2014. "The financial meltdown: a model with endogenous default probability," MPRA Paper 59419, University Library of Munich, Germany.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Vasco Cúrdia, 2005. "Monetary Policy under Sudden Stops," International Finance 0510025, University Library of Munich, Germany, revised 19 Dec 2005.
    2. Gulcin Ozkan & Filiz Unsal, "undated". "External finance, sudden stops and financial crisis: what is different this time?," Discussion Papers 09/22, Department of Economics, University of York.
    3. Frankel, Jeffrey, 2010. "Monetary Policy in Emerging Markets," Handbook of Monetary Economics, in: Benjamin M. Friedman & Michael Woodford (ed.), Handbook of Monetary Economics, edition 1, volume 3, chapter 25, pages 1439-1520, Elsevier.
    4. Fornaro, Luca, 2015. "Financial crises and exchange rate policy," Journal of International Economics, Elsevier, vol. 95(2), pages 202-215.
    5. Luca Fornaro, 2018. "International Debt Deleveraging," Journal of the European Economic Association, European Economic Association, vol. 16(5), pages 1394-1432.
    6. Piersanti, Giovanni, 2012. "The Macroeconomic Theory of Exchange Rate Crises," OUP Catalogue, Oxford University Press, number 9780199653126.
    7. Yildirim, Zekeriya, 2022. "Global financial risk, the risk-taking channel, and monetary policy in emerging markets," Economic Modelling, Elsevier, vol. 116(C).
    8. Cook, David & Devereux, Michael B., 2006. "External currency pricing and the East Asian crisis," Journal of International Economics, Elsevier, vol. 69(1), pages 37-63, June.
    9. Javier Gómez Pineda, 2004. "A Framework for Macroeconomic Stability in Emerging Market Economies," Borradores de Economia 320, Banco de la Republica de Colombia.
    10. Javier Gómez Pineda, 2004. "Inflation Targeting, Sudden Stops and the Cost of Fear of Floating," Borradores de Economia 276, Banco de la Republica de Colombia.
    11. Choi, Woon Gyu & Cook, David, 2004. "Liability dollarization and the bank balance sheet channel," Journal of International Economics, Elsevier, vol. 64(2), pages 247-275, December.
    12. Moron, Eduardo & Winkelried, Diego, 2005. "Monetary policy rules for financially vulnerable economies," Journal of Development Economics, Elsevier, vol. 76(1), pages 23-51, February.
    13. Louphou Coulibaly, 2023. "Monetary Policy in Sudden Stop-Prone Economies," American Economic Journal: Macroeconomics, American Economic Association, vol. 15(4), pages 141-176, October.
    14. Paul Levine, 2012. "Monetary policy in an uncertain world: probability models and the design of robust monetary rules," Indian Growth and Development Review, Emerald Group Publishing Limited, vol. 5(1), pages 70-88, April.
    15. Javier Gómez, 2004. "Inflation Targeting and Sudden Stops," Borradores de Economia 2854, Banco de la Republica.
    16. van Wijnbergen, Sweder & Jakucionyte, Egle, 2017. "Debt Overhang, Exchange Rates and the Macroeconomics of Carry Trade," CEPR Discussion Papers 11788, C.E.P.R. Discussion Papers.
    17. Elekdag, Selim & Tchakarov, Ivan, 2007. "Balance sheets, exchange rate policy, and welfare," Journal of Economic Dynamics and Control, Elsevier, vol. 31(12), pages 3986-4015, December.
    18. D. Filiz Unsal, 2013. "Capital Flows and Financial Stability: Monetary Policy and Macroprudential Responses," International Journal of Central Banking, International Journal of Central Banking, vol. 9(1), pages 233-285, March.
    19. Sangaré, Ibrahima, 2016. "External shocks and exchange rate regimes in Southeast Asia: A DSGE analysis," Economic Modelling, Elsevier, vol. 58(C), pages 365-382.
    20. Choi, Woon Gyu & Cook, David, 2012. "Fire sales and the financial accelerator," Journal of Monetary Economics, Elsevier, vol. 59(4), pages 336-351.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:red:sed008:474. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Christian Zimmermann (email available below). General contact details of provider: https://edirc.repec.org/data/sedddea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.