Persistent Appreciations and Overshooting: A Normative Analysis

50 Pages Posted: 24 Apr 2007

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Guido Lorenzoni

Northwestern University; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: April 19, 2007

Abstract

Most economies experience episodes of persistent real exchange rate appreciations, when the question arises whether there is a need for intervention to protect the export sector. In this paper we present a model of irreversible destruction where exchange rate intervention may be justified if the export sector is financially constrained. However the criterion for intervention is not whether there are bankruptcies or not, but whether these can cause a large exchange rate overshooting once the factors behind the appreciation subside. The optimal policy includes ex-ante and ex-post interventions. Ex-ante (i.e., during the appreciation phase) interventions have limited effects if the financial resources in the export sector are relatively abundant. In this case the bulk of the intervention takes place ex-post, and is concentrated in the first period of the depreciation phase. In contrast, if the financial constraint in the export sector is tight, the policy is shifted toward ex-ante intervention and it is optimal to lean against the appreciation. On the methodological front, we develop a framework to study optimal dynamic interventions in economies with financially constrained agents.

Keywords: Appreciations, overshooting, financial frictions, irreversible investment, pecuniary externality, real wages, optimal policy, exports

JEL Classification: E0, E2, F0, F4, H2

Suggested Citation

Caballero, Ricardo J. and Lorenzoni, Guido, Persistent Appreciations and Overshooting: A Normative Analysis (April 19, 2007). MIT Department of Economics Working Paper No. 07-13, Available at SSRN: https://ssrn.com/abstract=981909 or http://dx.doi.org/10.2139/ssrn.981909

Ricardo J. Caballero (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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Guido Lorenzoni

Northwestern University ( email )

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