Financial Intermediation, Exchange Rates, and Unconventional Policy in an Open Economy

35 Pages Posted: 6 Oct 2012 Last revised: 13 May 2021

See all articles by Luis Felipe Cespedes

Luis Felipe Cespedes

International Monetary Fund (IMF)

Roberto Chang

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences-New Brunswick/Piscataway - Department of Economics; National Bureau of Economic Research (NBER)

Andres Velasco

Columbia University - School of International & Public Affairs (SIPA)

Date Written: October 2012

Abstract

This paper develops an open economy model in which financial intermediation is subject to occasionally binding collateral constraints, and uses the model to study unconventional policies such as credit facilities and foreign exchange intervention. The model highlights the interaction between the real exchange rate, interest rates, and financial frictions. The exchange rate can affect the financial intermediaries' international credit limit via a net worth effect and a leverage ratio effect; the latter is novel and depends on the equilibrium link between exchange rates and interest spreads. Unconventional policies are nonneutral if and only if financial constraints are binding in equilibrium. Credit programs are more effective if targeted towards financial intermediaries rather than the corporate sector. Sterilized foreign exchange interventions matter because the increased availability of tradables, resulting from the sterilizing credit, can relax financial frictions; this perspective is new in the literature. Finally, self fulfilling expectations can lead to the coexistence of financially constrained and unconstrained equilibria, justifying a policy of defending the exchange rate and the accumulation of international reserves.

Suggested Citation

Cespedes, Luis Felipe and Chang, Roberto and Velasco, Andres, Financial Intermediation, Exchange Rates, and Unconventional Policy in an Open Economy (October 2012). NBER Working Paper No. w18431, Available at SSRN: https://ssrn.com/abstract=2157875

Luis Felipe Cespedes (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

Roberto Chang

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences-New Brunswick/Piscataway - Department of Economics ( email )

75 Hamilton Street
New Brunswick, NJ 08901
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Andres Velasco

Columbia University - School of International & Public Affairs (SIPA)

420 West 118th Street
New York, NY 10027
United States

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