Balance Sheets and Exchange Rate Policy

49 Pages Posted: 20 Aug 2000 Last revised: 5 Jun 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)

Andrés Velasco

Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)

Date Written: August 2000

Abstract

We study the relation among exchange rates, balance sheets, and macroeconomic outcomes in a small open economy. Because liabilities are dollarized,' a real devaluation has detrimental effects on entreprenurial net worth, which in turn constrains investment due to financial frictions. But there is an offsetting effect, int hat devaluation expands home output and the return to domestic investment, which are also components of net worth. We show that the impact of an adverse foreign shock can be strongly magnified by the balance sheet effect of the associated real devaluation. But the fall in output employment, and investment is stronger under fixed exchange rates than under flexible rates. Hence the conventional wisdom, that flexible exchange rates are better absorbers of real foreign shocks than are fixed rates, holds in spite of potentially large balance sheet effects.

Suggested Citation

Cespedes, Luis Felipe and Chang, Roberto and Velasco, Andrés, Balance Sheets and Exchange Rate Policy (August 2000). NBER Working Paper No. w7840, Available at SSRN: https://ssrn.com/abstract=239097

Luis Felipe Cespedes

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

Andrés Velasco (Contact Author)

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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