Working Paper: CEPR ID: DP2529
Authors: Philippe Aghion; Philippe Bacchetta; Abhijit Banerjee
Abstract: This paper presents a simple model of currency crises, which is driven by the interplay between the credit constraints of private domestic firms and the existence of nominal price rigidities. The possibility of multiple equilibria, including a ?currency crisis? equilibrium with low output and a depreciated domestic currency, results from the following mechanism: if nominal prices are ?sticky?, a currency depreciation leads to an increase in the foreign currency debt repayment obligations of firms, and thus to a fall in their profits; this reduces firms' borrowing capacity and therefore investment and output in a credit-constrained economy, which in turn reduces the demand for the domestic currency and leads to a depreciation. We examine the impact of various shocks, including productivity, fiscal, or expectational shocks. We then analyse the optimal monetary policy to prevent or solve currency crises. We also argue that currency crises can occur both under fixed and flexible exchange rate regimes as the primary source of crises is the deteriorating balance sheet of private firms.
Keywords: credit constraint; currency crisis; foreign currency debt
JEL Codes: E44; F30; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Currency Depreciation (F31) | Increased Foreign Currency Debt Repayment Obligations (F34) |
| Increased Foreign Currency Debt Repayment Obligations (F34) | Reduced Profits (D33) |
| Reduced Profits (D33) | Decreased Firms' Net Worth (G32) |
| Decreased Firms' Net Worth (G32) | Diminished Borrowing Capacity (G51) |
| Diminished Borrowing Capacity (G51) | Lower Investment (G31) |
| Lower Investment (G31) | Lower Output (E23) |
| Lower Output (E23) | Further Depreciation of Domestic Currency (F31) |