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): supply and demand shocks , financial crises , contractionary devaluation , Keynesian recession

JEL(s): E12 , E4 , E51 , F34 , G18

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5905.asp.asp

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.