The Transfer Problem and Real Exchange Rate Overshooting in Financial Crises: The Role of the Debt Servicing Multiplier*

Abstract

AbstractWe develop a real model of exchange rate overshooting due to a debt servicing multiplier. Borrowers of foreign capital are bound by noncontingent contracts to pay the world rate of return following an adverse shock. This is onerous, since the marginal product of capital is less than the world rate of return and the shock causes some capital to become extra‐marginal. If the resultant debt servicing shortfall is met by taxes on workers, this reduces their demand for nontradable goods, which feeds back onto their wage, reducing their demand for nontradable goods, etc. In the short run, when extra‐marginal projects are “stuck” in the economy, the real exchange rate can overshoot. This mechanism may help to explain overshooting of exchange rates in the 1997 Asian financial crisis.