Optimal Monetary Policy in a 'Sudden Stop'
Tilburg University - Center and Faculty of Economics and Business Administration; Tilburg University - European Banking Center
Lawrence J. Christiano
Northwestern University; Federal Reserve Bank of Cleveland; Federal Reserve Bank of Chicago; Federal Reserve Bank of Minneapolis; National Bureau of Economic Research (NBER)
Jorge E. Roldos
International Monetary Fund (IMF)
NBER Working Paper No. w13254
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: 50working papers series
Date posted: July 23, 2007
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