Optimal Monetary and Exchange Rate Policies in Crisis-Prone Small Open Economies

Banking crises are fairly ubiquitous events with large adverse consequences. This paper studies the potential for banking crises and their effects on exchange rate policies in a microfounded general equilibrium dynamic model in the tradition of Diamond and Dybvig (1983) and Chang and Velasco (2000). More specifically, 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 specific 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 banking crisis will occur. We provide a complete characterization of optimal interest rate policies in this setting. We find that nominal interest rates that are desirable from a welfare perspective may be associated with a high probability of banking crises. We go on to study the classic issue of the relative desirability of fixed versus flexible 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 fixed 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 flexible 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 flexible exchange rate regime is superior in an ex-ante welfare sense relative to the fixed exchange rate regime; however, the ordering is reversed when it comes to the likelihood of banking and currency crises. Very preliminary draft prepared for submission to conferences. The latest version can be downloaded from http://www.econ.iastate.edu/faculty/bhattacharya/work.htm 2 Joydeep Bhattacharya, Rajesh Singh