Net Worth, Exchange Rates, and Monetary Policy: The Effects of a Devaluation in a Financially Fragile Environment

37 Pages Posted: 9 Jul 2007 Last revised: 10 Sep 2010

See all articles by Domenico Delli Gatti

Domenico Delli Gatti

Universita' Cattolica, Milano

Mauro Gallegati

Università Politecnica delle Marche - Faculty of Economics

Bruce C. N. Greenwald

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Joseph E. Stiglitz

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Date Written: July 2007

Abstract

In this paper we propose an Open Economy Financial Accelerator model along the lines of Greenwald-Stiglitz (1993) close in spirit but different in many respects from the one proposed by Greenwald (1998.) The first goal of the paper is to provide a taxonomy of the effects of a devaluation in this context. The direct (first round) effect on output, taking as given net worth and interest rate, is negative for domestic firms (due to the input cost effect) and positive for exporting firms (due to a positive foreign debt effect). The indirect (second round) wealth effect (on output through net worth, taking as given the interest rate) is uncertain, depending on the relative size of the domestic and exporting firms. There is also an indirect effect on output through the response of the domestic interest rate to a devaluation due to the risk premium effect. Due to the uncertainty on the sign of most of these effects, it is difficult to assess the overall impact of a devaluation. One cannot rule out, however, an economy-wide contractionary effect of a devaluation. If the devaluation affects negatively the net worth of domestic firms, the domestic interest rate may rise (due to the risk premium effect), exerting an additional contractionary impact on output. If, on top of that, the monetary authorities force a further increase of the interest rate in an effort to curb the exchange rate, the contractionary effect will be emphasized.

Suggested Citation

Delli Gatti, Domenico and Gallegati, Mauro and Greenwald, Bruce and Stiglitz, Joseph E., Net Worth, Exchange Rates, and Monetary Policy: The Effects of a Devaluation in a Financially Fragile Environment (July 2007). NBER Working Paper No. w13244. Available at SSRN: https://ssrn.com/abstract=999039

Domenico Delli Gatti

Universita' Cattolica, Milano ( email )

20123 Milano
Italy
+39 02 72342499 (Phone)
+39 02 72342923 (Fax)

Mauro Gallegati

Università Politecnica delle Marche - Faculty of Economics ( email )

Piazzale Martelli, 8
60121 Ancona
Italy
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++390712207102 (Fax)

Bruce Greenwald (Contact Author)

Columbia Business School - Finance and Economics ( email )

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New York, NY 10027
United States
(212) 854-5553 (Phone)

National Bureau of Economic Research (NBER)

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Joseph E. Stiglitz

Columbia Business School - Finance and Economics ( email )

3022 Broadway
814 Uris Hall
New York, NY 10027
United States
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(212) 662-8474 (Fax)

HOME PAGE: http://www.josephstiglitz.com

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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