Monetary Policy under Sudden Stops

60 Pages Posted: 13 Mar 2007

See all articles by Vasco Cúrdia

Vasco Cúrdia

Federal Reserve Bank of San Francisco

Date Written: March 2007

Abstract

This paper proposes a model to investigate the effects of monetary policy in an emerging market economy that experiences a sudden stop of capital inflows. The model features credit frictions, debt denominated in foreign currency, imported inputs, and households that have access to the international capital market only indirectly, through their ownership of leveraged firms. The sudden stop is modeled as a change in the perceptions of foreign lenders that brings about an increase in the cost of borrowing. I show that the higher the elasticity of foreign demand, the lower the contraction in output - leading, at the extreme, to the possibility of an expansion, depending on policy. A second result is that the recession is most severe in a fixed exchange rate regime. Taylor rules that react to inflation and output are more stabilizing. A comparison of alternative rules shows that low commitment to inflation stabilization allows for less contraction in output and even expansion but at the cost of much stronger contraction in capital inflows and higher interest rates. Credibility is also shown to have an important role, with low credibility and the risk of loose policy implying increased trade-offs, stronger contraction of the economy, and higher interest rates.

Keywords: sudden stops, monetary policy, emerging markets, financial crises

JEL Classification: E5, F3, F4

Suggested Citation

Cúrdia, Vasco, Monetary Policy under Sudden Stops (March 2007). FRB of New York Staff Report No. 278, Available at SSRN: https://ssrn.com/abstract=970664 or http://dx.doi.org/10.2139/ssrn.970664

Vasco Cúrdia (Contact Author)

Federal Reserve Bank of San Francisco ( email )

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United States
(415) 977-3624 (Phone)

HOME PAGE: http://www.frbsf.org/economics/economists/staff.php?vcurdia

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