Fighting Against Currency Depreciation, Macroeconomic Instability, and Sudden Stops

Abstract

In this paper we show that, in the aftermath of a currency crisis, a government that adjusts the nominal interest rate in response to domestic currency depreciation can induce aggregate instability in the economy by generating self-fulfilling endogenous cycles. We find that, if a government raises the interest rate proportionally more than an increase in currency depreciation, then it induces selffulfilling cycles that, driven by people's expectations about depreciation, replicate several of the salient stylized facts of the "Sudden Stop" phenomenon. These facts include a decline in domestic production and aggregate demand, a collapse in asset prices, a sharp correction in the price of traded goods relative to non-traded goods, an improvement in the current account deficit, a moderately higher CPI-inflation, more rapid currency depreciation, and higher nominal interest rates. In this sense, an interest rate policy that responds to depreciation may have contributed to generating the dynamic cycles experienced by some economies in the aftermath of a currency crisis.

Keywords: Small Open Economy, Interest Rate Policies, Currency Depreciation, Self-fulfilling Cycles, Sudden Stops, Collateral Constraints

JEL Classification: E32, E52, E58, F41