Emerging markets, household heterogeneity, and exchange rate policy

I argue that household heterogeneity plays a key role in the transmission of aggregate shocks in emerging market economies. Using Mexico's 1995 crisis as a case study, I first document empirically that working in the tradable versus non-tradable sector is a crucial determinant of the income and consumption losses of different types of households. Specifically, households in the non-tradable sector suffered much larger income and consumption losses regardless of other household characteristics. To account for the effect of this observation on macroeconomic dynamics, I construct a New Keynesian small open economy model with household heterogeneity along two dimensions: uninsurable sector-specific income and limited financial-market participation. I find that the propagation of shocks in this economy is affected by both dimensions of heterogeneity, with uninsurable sector-specific income playing a quantitatively larger role. In terms of policy, a managed exchange rate policy is more costly overall when households are heterogeneous; however, households in the non-tradable sector benefit from it.