Working Paper: NBER ID: w10128
Authors: Mark Gertler; Simon Gilchrist; Fabio Natalucci
Abstract: We develop a small open economy macroeconomic model where financial conditions influence aggregate behavior. We use this model to explore the connection between the exchange rate regime and financial distress. We show that fixed exchange rates exacerbate financial crises by tieing the hands of the monetary authorities. We then investigate the quantitative significance by first calibrating the model to Korean data and then showing that it does a reasonably good job of matching the Korean experience during its recent financial crisis. In particular, the model accounts well for the sharp increase in lending rates and the large drop in output, investment and productivity during the 1997-1998 episode. We then perform some counterfactual exercises to illustrate the quantitative significance of fixed versus floating rates both for macroeconomic performance and for welfare. Overall, these exercises imply that welfare losses following a financial crisis are significantly larger under fixed exchange rates relative to flexible exchange rates.
Keywords: monetary policy; financial accelerator; exchange rate regime; financial crises
JEL Codes: E5; F3; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fixed exchange rates (F31) | financial crises (G01) |
| limited monetary policy response (E49) | severe financial distress (G33) |
| fixed exchange rates (F31) | increase in interest rates (E43) |
| increase in interest rates (E43) | negative impact on lending (F65) |
| increase in interest rates (E43) | negative impact on output (F69) |
| increase in interest rates (E43) | negative impact on productivity (F66) |
| financial accelerator mechanism (E44) | decline in economic activity (F44) |
| fixed exchange rates (F31) | larger welfare losses (D69) |
| fixed exchange rates (F31) | drop in output (E23) |
| reductions in capital utilization (G31) | drop in productivity (O49) |