Essays on monetary and exchange rate policy in financially fragile economies

Field: Economics, Econometrics and Finance (Social Sciences)

In my thesis I study policy interventions, with particular attention to monetary and exchange rate policy, in financially fragile economies. The thesis is composed of four chapters, and each chapter deals with different forms of policy interventions and different dimensions of financial fragility. However, the four chapters share a common message: appropriately designed policies can play a key role in improving macroeconomic performance in economies vulnerable to the risk of financial crises. \nIn the first chapter I consider the role of the exchange rate regime in determining the adjustment to episodes of global deleveraging. To achieve this goal, I develop a framework for understanding the international dimensions of episodes of debt deleveraging. During an episode of international deleveraging world consumption demand is depressed and the world interest rate is low, reflecting a high propensity to save. If exchange rates are allowed to float, deleveraging countries can depreciate their nominal exchange rate to increase production and mitigate the fall in consumption associated with debt reduction. The key insight is that in a monetary union this channel of adjustment is shut off, and therefore the falls in consumption demand and in the world interest rate are amplified. Hence, monetary unions are especially prone to hit the zero lower bound on the nominal interest rate and enter a liquidity trap during deleveraging. In a liquidity trap deleveraging gives rise to a union-wide recession, which is particularly severe in high-debt countries. The model suggests several policy interventions that mitigate the negative impact of deleveraging on output in monetary unions. \nIn the second chapter, I consider another policy that can be useful in managing episodes of debt deleveraging: debt relief. As illustrated by the analysis in the first chapter, deleveraging can push the economy into a liquidity trap characterized by involuntary unemployment and low inflation. A debt relief policy, captured by a transfer of wealth from creditors to debtors, increases aggregate demand, employment and output. Debt relief may benefit creditors as well as debtors and lead to a Pareto improvement in welfare. The benefits from a policy of debt relief are greater the more the central bank is concerned with stabilizing inflation. \nThe third chapter considers the role of exchange rate policy in economies in which financial fragility arises because the value of collateral is determined by asset prices. The dependence of collateral on asset prices introduces pecuniary externalities that create scope for policy interventions. In this case, a fundamental trade-off between financial and price stability arises, because the central bank has an incentive to deviate from its traditional objective of granting price stability in order to manipulate asset prices and collateral. The main result is thus that the presence of pecuniary externalities in the credit markets makes a narrow focus on price stability sub-optimal. \nThe fourth chapter, joint with Gianluca Benigno, considers the role of foreign reserves in emerging economies characterized by growth externalities and the risk of sudden stops on capital inflows. We present a model that reproduces two salient facts characterizing the international monetary system: Fast growing emerging countries i) Run current account surpluses, ii) Accumulate international reserves and receive net private inflows. We study a two-sector, tradable and non-tradable, small open economy. There is a growth externality in the tradable sector and agents have imperfect access to international financial markets. By accumulating foreign reserves, the government induces a real exchange rate depreciation and a reallocation of production towards the tradable sector that boosts growth. Financial frictions generate imperfect substitutability between private and public debt flows so that private agents do not perfectly offset the government policy. The possibility of using reserves to provide liquidity during crises amplifies the positive impact of reserve accumulation on growth. The optimal reserve management entails a fast rate of reserve accumulation, as well as higher growth and larger current account surpluses compared to the economy with no policy intervention. The model is also consistent with the negative relationship between inflows of foreign aid and growth observed in low-income countries.