DP5905 Supply Shocks and Currency Crises: The Policy Dilemma Reconsidered

Author(s): Javier García-Fronti, Marcus Miller, Lei Zhang
Publication Date: October 2006
Keyword(s): contractionary devaluation, financial crises, Keynesian recession, supply and demand shocks
JEL(s): E12, E4, E51, F34, G18
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5905

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.