Optimal Exchange Rate Policy Under Collateral Constraints and Wage Rigidity

Ottonello, Pablo

Existing literature on small open economies has studied separately two opposite effects of currency depreciation during crises: in the presence of nominal wage rigidity, exchange rate depreciation reduces unemployment; in the presence of collateral constraints that link external debt to the value of income, exchange rate depreciation tightens the collateral constraint and leads to higher consumption adjustment. This paper shows that in a model that includes both frictions, exchange rate policy faces a “credit access - unemployment trade-off," i.e., a trade-off between reducing involuntary unemployment and relaxing the external credit limit. A quantitative study of this model shows that during financial crisis episodes, optimal policy features large nominal and real exchange rate depreciation. This is because, while containing real exchange rate depreciation can have welfare gains related to second moments (lower consumption volatility) its costs are related to first-moments (higher average unemployment rate). The optimal policy implies a lower currency depreciation than that necessary to achieve full employment, which is consistent with “managed-floating" exchange rate policy, typically observed during financial crises in emerging economies. Sudden Stops (or large current account adjustments) are part of the endogenous response under the optimal exchange rate policy to large negative shocks.



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More About This Work

Academic Units
Department of Economics, Columbia University
Department of Economics Discussion Papers, 1213-25
Published Here
June 17, 2013