Liquidity Shocks and Optimal Monetary and Exchange Rate Policies in a Small Open Economy

This paper studies the potential for liquidity crises and their impact on the course of monetary and exchange rate policies in a microfounded general equilibrium dynamic model in the tradition of Diamond and Dybvig (1983) and Chang and Velasco (2000). We produce a small open economy pure exchange overlapping generations model with random relocation along the lines of Smith (2002). The combination of random relocation and the assumed role of currency in interlocation trade creates random location and country speci…c liquidity needs. Banks naturally arise to provide much-desired insurance against these liquidity shocks. In this setting, if withdrawal demand for the bank’s deposits is high enough, the bank will exhaust all its cash reserves and a liquidity shortage will occur. We provide a complete characterization of optimal interest rate policies in this setting. In a deterministic set up, we …nd that nominal interest rates that are desirable from a welfare perspective may also lower the probability of a liquidity crisis. We go on to study the classic issue of the relative desirability of …xed versus ‡exible exchange rate regimes by introducing time-varying random endowments into the above structure. This makes the banks’portfolio allocations dependent on the exchange rate regime. Under a …xed exchange rate regime, by interest rate parity, the banks’portfolio choice is deterministic and constant over time and this is supported by the injection/removal of nominal balances by the central bank. Under a ‡exible exchange rate regime, the money supply stays constant but a rate-of-return uncertainty emerges that is in addition to the income uncertainty common to both regimes. Our results show that a ‡exible exchange rate regime is superior in an ex-ante welfare sense relative to the …xed exchange rate regime; however, the ordering is reversed when it comes to the likelihood of liquidity crisis. ? Very preliminary draft prepared for submission to conferences. The latest version can be downloaded from http://www.econ.iastate.edu/faculty/singh/WorkingPapers/OMPLP.pdf 2 Joydeep Bhattacharya, Rajesh Singh