External constraints on monetary policy and the financial accelerator

We develop a small open economy macroeconomic model where financial conditions influence aggregate behavior. We use this model to explore the connection between the exchange rate regime and financial distress. Fixed exchange rates are shown to exacerbate financial crises. Quantitative exercises calibrated to match the Korean experience during the recent Asian crisis are able to replicate key macroeconomic outcomes including the sharp increase in lending rates and the observed drop in output, investment and productivity during the 1997-1998 episode. These exercises imply that welfare losses following a financial crisis are significantly larger under fixed exchange rates relative to flexible exchange rates.

On 28-29 March 2003, the BIS held a conference on "Monetary stability, financial stability and the business cycle". This event brought together central bankers, academics and market participants to exchange views on this issue (see the conference programme and list of participants in this document). This paper was presented at the conference. Also included in this publication are the comments by the discussants. The views expressed are those of the author(s) and not those of the BIS. The opening speech at the conference by the BIS General Manager and the prepared remarks of the four participants on the policy panel are being published in a single volume in the BIS Papers series.