Working Paper: NBER ID: w18431
Authors: Luis Felipe Cespedes; Roberto Chang; Andres Velasco
Abstract: This paper develops an open economy model in which financial intermediation is subject to occasionally binding collateral constraints, and uses the model to study unconventional policies such as credit facilities and foreign exchange intervention. The model highlights the interaction between the real exchange rate, interest rates, and financial frictions. The exchange rate can affect the financial intermediaries' international credit limit via a net worth effect and a leverage ratio effect; the latter is novel and depends on the equilibrium link between exchange rates and interest spreads. Unconventional policies are nonneutral if and only if financial constraints are binding in equilibrium. Credit programs are more effective if targeted towards financial intermediaries rather than the corporate sector. Sterilized foreign exchange interventions matter because the increased availability of tradables, resulting from the sterilizing credit, can relax financial frictions; this perspective is new in the literature. Finally, self fulfilling expectations can lead to the coexistence of financially constrained and unconstrained equilibria, justifying a policy of defending the exchange rate and the accumulation of international reserves.
Keywords: Financial Intermediation; Exchange Rates; Unconventional Policy; Open Economy
JEL Codes: E58; F34; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| unconventional policies (E65) | effectiveness of policies (F68) |
| financial constraints bind in equilibrium (D10) | effectiveness of unconventional policies (E65) |
| targeting of policies (F68) | effectiveness of credit programs (H81) |
| sterilized foreign exchange interventions (F31) | relaxation of financial frictions (G19) |
| real exchange rate depreciation (F31) | negative impact on credit limit of banks (G21) |
| government credit programs (H81) | alleviation of financial constraints (F35) |
| government's commitment to intervene in exchange rate (F31) | prevention of shift from good equilibrium to bad equilibrium (C62) |