Currency Crisis, Monetary Policy, and Corporate Balance Sheet Vulnerabilities

Abstract

This paper studies how the exposure of a country's corporate sector to interest rate and exchange rate changes affects the probability of a currency crisis. To analyze this question, we present a model that defines currency crisis as situations in which the costs of maintaining a fixed exchange rate exceed the costs of abandonment. The results show that a higher exposure to interest rate changes increases the probability of crisis through an increased need for output loss compensation and an increased efficacy of monetary policy in stimulating output. A higher exposure to exchange rate changes also increases the need for output loss compensation. However, it lowers the efficacy of monetary policy in stimulating output through the adverse balance sheet effects of exchange rate depreciation. As a result, its effects on the probability of crisis is ambiguous.

Keywords: currency, financial crisis, monetary policy, foreign debt, balance sheets, short term debt

JEL Classification: E52, E58, F34