Conference Paper

External constraints on monetary policy and the financial accelerator

Abstract: This paper incorporates a financial accelerator mechanism in a small open economy macro model with money and nominal price rigidities. Our goal is to explore the connection between financial distress that feeds into the real economy and the exchange rate regime. Our principle finding is that financial accelerator effects are much stronger under fixed rates than under flexible rates (with a suitably managed monetary policy). Roughly speaking, an exchange rate peg forces the central bank to adjust the interest rate in a manner that enhances the financial distress. This occurs even when debt is denominated in units of foreign currency. Finally, unexpectedly delaying the abandonment of an exchange rate peg several quarters after a shock can produce distress nearly as bad as occurs under a permanent peg, due to the unanticipated contractions in asset prices.

Keywords: Foreign exchange rates; Monetary policy;

Status: Published in Asset prices, exchange rates, and monetary policy : a conference (2001: March 2-3)

Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Proceedings

Publication Date: 2001

Issue: Mar