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Financial crises and exchange rate policy

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Abstract

This paper studies exchange rate policy in a small open economy model featuring an occasionally binding collateral constraint and Fisherian deflation. The goal is to evaluate the performance of alternative exchange rate policies in sudden stop-prone economies. The key element of the analysis is a pecuniary externality arising from frictions in the international credit markets, which creates a trade-off between price and financial stability. The main result is that devaluing the exchange rate during a financial crisis has a positive impact on welfare, because the stimulus provided by a devaluation sustains asset prices, the value of collateral, and access to the international credit markets.

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  • Luca Fornaro, 2014. "Financial crises and exchange rate policy," Economics Working Papers 1431, Department of Economics and Business, Universitat Pompeu Fabra, revised Nov 2014.
    • Handle: RePEc:upf:upfgen:1431
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    More about this item

    Keywords

    Financial crises; Monetary Policy; Sudden Stops; Exchange Rate Regime; Nominal Wage Rigidities; Pecuniary Externalities.;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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