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Optimal Monetary Policy in a 'Sudden Stop'Fabio BraggionTilburg University - Center and Faculty of Economics and Business Administration; Tilburg University - European Banking Center Lawrence J. ChristianoNorthwestern University; Federal Reserve Bank of Cleveland; Federal Reserve Bank of Chicago; Federal Reserve Bank of Minneapolis; National Bureau of Economic Research (NBER) Jorge E. RoldosInternational Monetary Fund (IMF) July 2007 NBER Working Paper No. w13254 Abstract: In the wake of the 1997-98 financial crises, interest rates in Asia were raised immediately, and then reduced sharply. We describe an environment in which this is the optimal monetary policy. The optimality of the immediate rise in the interest rate is an example of the theory of the second best: although high interest rates introduce an inefficiency wedge into the labor market, they are nevertheless welfare improving because they mitigate distortions due to binding collateral constraints. Over time, as various real frictions wear off and the collateral constraint is less binding, the familiar Friedman forces dominate, and interest rates are optimally set as low as possible.
Number of Pages in PDF File: 50 working papers seriesDate posted: July 23, 2007Suggested CitationContact Information
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