Working Paper: NBER ID: w30897
Authors: Javier Bianchi; Louphou Coulibaly
Abstract: Many central banks whose exchange rate regimes are classified as flexible are reluctant to let the exchange rate fluctuate. This phenomenon is known as “fear of floating”. We present a simple theory in which fear of floating emerges as an optimal policy outcome. The key feature of the model is an occasionally binding borrowing constraint linked to the exchange rate that introduces a feedback loop between aggregate demand and credit conditions. Contrary to the Mundellian paradigm, we show that a depreciation can be contractionary, and letting the exchange rate float can expose the economy to self-fulfilling crises.
Keywords: No keywords provided
JEL Codes: E44; E52; F33; F34; F36; F41; F45; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Nominal exchange rate depreciation (F31) | Contraction in demand for non-tradable goods (J49) |
| Nominal exchange rate depreciation (F31) | Pessimism among households regarding their financial situation (D12) |
| Pessimism among households regarding their financial situation (D12) | Reduced borrowing and consumption (G51) |
| Reduced borrowing and consumption (G51) | Real exchange rate depreciation (F31) |
| Real exchange rate depreciation (F31) | Tighter borrowing constraints (F65) |
| Tighter borrowing constraints (F65) | Pessimism among households regarding their financial situation (D12) |
| Nominal exchange rate depreciation (F31) | Self-fulfilling crisis equilibrium (D59) |
| Anchoring the nominal exchange rate (F31) | Stabilization of the economy (E63) |