External Constraints on Monetary Policy and the Financial Accelerator / Mark Gertler, Simon Gilchrist, Fabio Natalucci.

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Gertler, Mark

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w10128.Publication details: Cambridge, Mass. National Bureau of Economic Research 2003.Description: 1 online resource: illustrations (black and white)Subject(s):

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Abstract: We develop a small open economy macroeconomic model where financial conditions influence aggregate behavior. We use this model to explore the connection between the exchange rate regime and financial distress. We show that fixed exchange rates exacerbate financial crises by tieing the hands of the monetary authorities. We then investigate the quantitative significance by first calibrating the model to Korean data and then showing that it does a reasonably good job of matching the Korean experience during its recent financial crisis. In particular, the model accounts well for the sharp increase in lending rates and the large drop in output, investment and productivity during the 1997-1998 episode. We then perform some counterfactual exercises to illustrate the quantitative significance of fixed versus floating rates both for macroeconomic performance and for welfare. Overall, these exercises imply that welfare losses following a financial crisis are significantly larger under fixed exchange rates relative to flexible exchange rates.

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Previous	nber w10125 International Lending of Last Resort and Moral Hazard: A Model of IMF's Catalytic Finance /	nber w10126 Legal Institutions and Financial Development /	nber w10127 Health Plan Conversions: Are They in the Public Interest? /	nber w10128 External Constraints on Monetary Policy and the Financial Accelerator /	nber w10129 Law and Employment: Lessons from Latin America and the Caribbean /	nber w1013 The Proper Measurement of Government Budget Deficits: Comprehensive Wealth Accounting or Permanent Income Accounting for the Public Sector /	nber w10130 Have National Business Cycles Become More Synchronized? /	Next

December 2003.

We develop a small open economy macroeconomic model where financial conditions influence aggregate behavior. We use this model to explore the connection between the exchange rate regime and financial distress. We show that fixed exchange rates exacerbate financial crises by tieing the hands of the monetary authorities. We then investigate the quantitative significance by first calibrating the model to Korean data and then showing that it does a reasonably good job of matching the Korean experience during its recent financial crisis. In particular, the model accounts well for the sharp increase in lending rates and the large drop in output, investment and productivity during the 1997-1998 episode. We then perform some counterfactual exercises to illustrate the quantitative significance of fixed versus floating rates both for macroeconomic performance and for welfare. Overall, these exercises imply that welfare losses following a financial crisis are significantly larger under fixed exchange rates relative to flexible exchange rates.