Supply Shocks and Currency Crises: The Policy Dilemma Reconsidered

Abstract

The stylised facts of currency crises in emerging markets include output contraction coming hard on the heels of devaluation, with a prominent role for the adverse balance-sheet effects of liability dollarisation. In the light of the South East Asian experience, we propose an eclectic blend of the supply-side account of Aghion, Bacchetta and Banerjee (2000) with a demand recession triggered by balance sheet effects (Krugman, 1999). This sharpens the dilemma facing the monetary authorities - how to defend the currency without depressing the economy. But, with credible commitment or complementary policy actions, excessive output losses can, in principle, be avoided.

Keywords: Supply and demand shocks, financial crises, contractionary devaluation, Keynesian recession

JEL Classification: E12, E4, E51, F34, G18