Balance Sheets and Monetary Policy in the Open Economy: A Research Proposal

The design and analysis of exchange rate regimes has long been a research priority. The subject has attracted even more attention recently because of the emerging-market crises of the 1990s, and the ensuing controversies over how the exchange rate was managed. In those episodes the domestic financial system often crashed along with the currency. Moreover, financial considerations -such as the health of banks or the size of dollar debt posed severe constraints on the conduct of monetary policy. For these reasons, increasingly the focus of research is on the interaction between the structure of the financial systems and the effects of exchange rate policy. For instance recent work has stressed that in the presence of liabilities denominated in foreign currency a devaluation can weaken the balance sheets of domestic firms and reduce their access to world credit markets thus causing a fall in investment. aggregate demand. and output. In joint work with Luis Felipe Cespedes of NYU, the investigators were among the first to model this channel in the context of a dynamic stochastic general equilibrium model and to explore its implications for monetary and exchange rate policies. But the literature that studies monetary policies in open economies with imperfect fi-nancial markets is still in its infancy. This project advances this line of work in two directions:

(i) It develops formal models of how exchange rate policy may have an impact on overall activity through the effect of exchange rates on balance sheets and, more generally, on credit constraints. Previous work relied on some very strong simplifying assumptions.

(ii) It analyzes the proper choice of monetary and exchange rate policy. Almost all papers so far have looked at once and for all monetary reactions to a particular shock. This project characterizes the optimal monetary policy rule with and without commitment.

The theoretical results, and the quantitative implications of calibrated simulations of the models could have important implications for a number of policy issues. Could floating be the optimal exchange rate policy in the presence of financial imperfections? What is the optimal monetary policy in a floating regime? In particular. how close should the correlation be between home and foreign nominal interest rates? Can the optimal policy be replicated or approximated by an inflation-targeting rule? If so. how should that rule be designed?