Currency Crises and Monetary Policy in an Economy with Credit Constraints

Studienzentrum Gerzensee Working Paper No. 00.07

43 Pages Posted: 20 Sep 2000

See all articles by Philippe Aghion

Philippe Aghion

College de France and London School of Economics and Political Science, Fellow; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Abhijit V. Banerjee

Massachusetts Institute of Technology (MIT) - Department of Economics

Philippe Bacchetta

University of Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Date Written: June 2000

Abstract

This paper presents a simple model of currency crises which is driven by the interplay between the credit constraints of private domestic firms and the existence of nominal price rigidities. The possibility of multiple equilibria, including a 'currency crisis' equilibrium with low output and a depreciated domestic currency, results from the following mechanism: if nominal prices are 'sticky', a currency depreciation leads to an increase in the foreign currency debt repayment obligations of firms, and thus to a fall in their profits; this reduces firms' borrowing capacity and therefore investment and output in a credit-constrained economy, which in turn reduces the demand for the domestic currency and leads to a depreciation. We examine the impact of various shocks, including productivity, fiscal, or expectational shocks. We then analyze the optimal monetary policy to prevent or solve currency crises. We also argue that currency crises can occur both under fixed and flexible exchange rate regimes as the primary source of crises is the deteriorating balance sheet of private firms.

Keywords: currency crisis, foreign currency debt, credit constraint

JEL Classification: F3, E44, F41

Suggested Citation

Aghion, Philippe and Banerjee, Abhijit V. and Bacchetta, Philippe, Currency Crises and Monetary Policy in an Economy with Credit Constraints (June 2000). Studienzentrum Gerzensee Working Paper No. 00.07. Available at SSRN: https://ssrn.com/abstract=239288 or http://dx.doi.org/10.2139/ssrn.239288

Philippe Aghion

College de France and London School of Economics and Political Science, Fellow ( email )

London
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Abhijit V. Banerjee

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

50 Memorial Drive
Room E52-252D
Cambridge, MA 02142
United States
617-253-8855 (Phone)
617-253-6915 (Fax)

Philippe Bacchetta (Contact Author)

University of Lausanne ( email )

Faculty of Business and Economics
Internef 523
1015 Lausanne
Switzerland

HOME PAGE: http://www.hec.unil.ch/pbacchetta/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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