Exchange Rate Adjustment in Financial Crises

Abstract

This paper studies the positive and normative effects of alternative monetary and exchange rate polices in a small open economy model subject to occasional “sudden stops” associated with binding borrowing constraints. Borrowing constraints in the model depend on endogenous movements in asset prices. We find that in normal times, there is little difference between alternative exchange rate policies. But during a crisis, macroeconomic outcomes are far worse under a pegged exchange rate regime. Under some shock configurations, crises may be less frequent under a pegged exchange rate regime, but the worse performance during a crisis leads the pegged exchange regime to be inferior to the floating regimes. Finally, we show that in the presence of pecuniary externalities in asset prices, there may be a case for a fiscal authority to subsidize capital inflows at a constant rate. But the benefits of capital inflow subsidies are much weaker under pegged exchange rates.