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Journal Article
Policy implications of the New Keynesian Phillips curve
This article surveys recent advancements in the theory of optimal monetary policy in models with a New Keynesian Phillips curve. It identifies four policy implications. First, near price stability is optimal. Second, simple interest rate feedback rules that respond aggressively to price inflation deliver near-optimal equilibrium allocations. Third, interest rate rules that respond to deviations of output from trend may carry significant welfare costs. Fourth, the zero bound on nominal interest rates does not appear to be a significant obstacle for the actual implementation of low and stable ...
Working Paper
Comparing the welfare costs and the initial dynamics of alternative temporary stabilization policies
This paper compares the welfare costs and initial dynamics of three alternative inflation stabilization policies using the staggered price model with imperfect credibility and currency substitution developed by Calvo and Vegh (1990). In addition to the policies analyzed by Calvo and Vegh (1990)--a temporary exchange-rate based stabilization program (ERB) and a temporary money based program (MB)--this paper considers a third stabilization policy consisting of a temporary money based program with initial reliquefication--i.e., an initial once-and-for-all increase in the money supply--that keeps ...
Working Paper
Country spreads and emerging countries
A number of studies have stressed the role of movements in U.S. interest rates and country spreads in driving business cycles in emerging market economies. At the same time, country spreads have been found to respond to changes in both the U.S. interest rate and domestic conditions in emerging markets. These intricate interrelationships leave open a number of fundamental questions: Do country spreads drive business cycles in emerging countries or vice versa, or both? Do U.S. interest rates affect emerging countries directly or primarily through their effect on country spreads? This paper ...
Working Paper
The business cycles of currency speculation: a revision of the Mundellian framework
In his seminal 1960 study on the dynamics of alternative exchange rate regimes, Robert Mundell proposed a theory of balance-of-payments crises in which speculators base their actions on the observed holdings of central bank foreign reserves. We examine the quantitative implications of this view from the perspective of an equilibrium business cycle model in which rational expectations of a devaluation are conditioned on foreign reserves. The model explains some of the empirical regularities of the business cycle associated with temporary fixed-exchange-rate regimes. In turn, these cyclical ...
Working Paper
A model of the Twin Ds: optimal default and devaluation
This paper characterizes jointly optimal default and exchange-rate policy in a small open economy with limited enforcement of debt contracts and downward nominal wage rigidity. Under optimal policy, default occurs during contractions and is accompanied by large devaluations. The latter inflate away real wages, thereby avoiding massive unemployment. Thus, the Twin Ds phenomenon emerges endogenously as the optimal outcome. In contrast, under fixed exchange rates, optimal default takes place in the context of large involuntary unemployment. Fixed-exchange-rate economies are shown to have ...
Working Paper
The Tequila effect: theory and evidence from Argentina
The Tequila Effect hypothesis states that the economic crisis that affected several South American countries in 1995 was caused by an exogenous capital flight triggered by the loss of confidence of foreign investors after the collapse of the Mexican peso in December 1994. I analyze the recent Argentine experience before and after the Mexican crisis and argue that the Tequila Effect played an important role in the 1995 crisis. I model the Tequila Effect in an optimizing, small, open economy, as a situation in which agents at time 0 learn that at some random future date foreign investors will ...
Working Paper
Backward-looking interest-rate rules, interest-rate smoothing, and macroeconomic instability
The existing literature on the stabilizing properties of interest-rate feedback rules has stressed the perils of linking interest rates to forecasts of future inflation. Such rules have been found to give rise to aggregate fluctuations due to self-fulfilling expectations. In response to this concern, a growing literature has focused on the stabilizing properties of interest-rate rules whereby the central bank responds to a measure of past inflation. The consensus view that has emerged is that backward-looking rules contribute to protecting the economy from embarking on expectations-driven ...
Conference Paper
Country spreads and emerging countries: who drives whom?
A number of studies have stressed the role of movements in US interest rates and country spreads in driving business cycles in emerging market economies. At the same time, country spreads have been found to respond to changes in both the US interest rate and domestic conditions in emerging markets. These intricate interrelationships leave open a number of fundamental questions: Do country spreads drive business cycles in emerging countries or vice versa, or both? Do US interest rates affect emerging countries directly or primarily through their effect on country spreads? This paper addresses ...
Working Paper
Real exchange rate targeting and macroeconomic instability
This paper introduces a real exchange rate rule of the type analyzed by Dornbusch (1982) in an optimizing, two-sector, monetary model of a small open economy. By this rule the government increases the devaluation rate when the real exchange rate is below its long-run level and reduces it when the real exchange rate is above its long-run level. I show that the mere existence of such a rule can give room for extrinsic uncertainty to have real effects, that is, it can generate economic fluctuations due to self-fulfilling expectations. I also analyze the stabilizing role of these PPP rules when ...
Working Paper
Optimal simple and implementable monetary and fiscal rules
This paper computes welfare-maximizing monetary and fiscal policy rules in a real business cycle model augmented with sticky prices, a demand for money, taxation, and stochastic government consumption. We consider simple feedback rules whereby the nominal interest rate is set as a function of output and inflation and taxes are set as a function of total government liabilities. We implement a second-order accurate solution to the model. We have several main findings. First, the size of the inflation coefficient in the interest rate rule plays a minor role for welfare. It matters only insofar ...