Monetary Policy in an International Financial Crisis

Abstract

We explore the role of monetary policy in the aftermath of a financial crisis. We develop a small open economy model with limited participation of households in a financial intermediary that provides liquidity to satisfy firms' working capital needs. Firms require two forms of working capital: domestic funds to pay for the wage bill and foreign funds to finance imports of intermediate goods. A shortage of either one of the sources of working capital acts as a drag on economic activity. In normal times, an interest rate cut is expansionary. In a financial crisis, collateral constraints bind and an expansion of domestic liquidity leads to a real exchange rate depreciation that further tightens the collateral constraint and offsets the traditional (expansionary) liquidity channel. In addition, the tightening of the collateral constraint places a premium on paying off foreign debt, reinforcing the contractionary effects of an interest rate cut. We study the conditions under which such monetary policy action is contractionary and relate them to recent emerging market crises.