Balance Sheets and Exchange Rate Policy

In conventional textbook accounts, expansionary monetary policy and depreciation of the currency are optimal in response to an adverse foreign shock. But if an economy has a large debt denominated in foreign currency, then a weaker local currency can also exacerbate debt-service difficulties and wreck the balance sheets of domestic banks and firms. This channel may cause devaluations to be contractionary, not expansionary. This paper develops a model in which liabilities are dollarized and the country risk premium is endogenously determined by domestic net worth, in the manner of Ben Bernanke and Mark Gertler. Wages are sticky in terms of the home currency, so that monetary and exchange rate policies have real effects. And in contrast with other models of balance sheet effects in the open economy, this model is a dynamic general-equilibrium one built from first principles, yet solvable analytically. The paper provides a complete characterization of the model's implications, including welfare, and addresses topical questions - in particular, whether flexible exchange rates provide insulation in the presence of imperfect financial markets and dollarized liabilities.