DP11432 The Case for Flexible Exchange Rates in a Great Recession

Author(s): Giancarlo Corsetti, Keith Kuester, Gernot Müller
Publication Date: August 2016
Keyword(s): Benign coincidence, Exchange rate, external shock, External-demand multiplier, Fiscal Multiplier, great recession, zero lower bound
JEL(s): E31, F41, F42
Programme Areas: International Macroeconomics and Finance
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=11432

We analyze macroeconomic stabilization in a small open economy which faces a large recession in the rest of the world. We show that for the economy to remain isolated from the shock, the exchange rate must depreciate not only to offset the collapse in external demand, but also to decouple domestic prices from deflation in the rest of the world. If monetary policy becomes constrained by the zero lower bound, the scope of exchange rate depreciation is limited. Still, in this case there is a ``benign coincidence": fiscal policy is particularly effective in stabilizing economic activity. Under fixed exchange rates, instead, the impact of the external shock is particularly severe and the effectiveness of fiscal policy reduced.