Working Paper: CEPR ID: DP3092
Authors: Philippe Aghion; Philippe Bacchetta; Abhijit Banerjee
Abstract: This Paper presents a general equilibrium currency crisis model of the 'third generation', in which the possibility of currency crises is driven by the interplay between private firms' credit-constraints and nominal price rigidities. Despite our emphasis on microfoundations, the model remains sufficiently simple that the policy analysis can be conducted graphically. The analysis hinges on four main features: i) ex post deviations from purchasing power parity; ii) credit constraints a la Bernanke-Gertler; iii) foreign currency borrowing by domestic firms; iv) a competitive banking sector lending to firms and holding reserves and a monetary policy conducted either through open market operations or short-term lending facilities. We first show that with a positive likelihood of a currency crisis, firms may indeed find it optimal to borrow in foreign currency, following Chamon (2001). Second, we derive sufficient conditions for the existence of a sunspot equilibrium with currency crises. Third, we show that a reduction in the monetary base through restrictive open market operations is more likely to eliminate the possibility of currency crises if at the same time the central bank does not impose excessive constraints on short-term lending facilities.
Keywords: financial crisis; foreign currency debt; monetary policy
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) | Foreign currency debt burden (F34) |
| Foreign currency debt burden (F34) | Reduced profits (D33) |
| Reduced profits (D33) | Reduced net worth (G32) |
| Reduced net worth (G32) | Lower investment (G31) |
| Lower investment (G31) | Reduced economic activity (F69) |
| Reduced economic activity (F69) | Further currency depreciation (F31) |
| Credit constraints (E51) | Limiting firms' ability to invest (D25) |
| Currency crisis (F31) | Interplay of factors (D91) |