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Financial Crises, Bailouts and Monetary Policy in Open Economies

Yang Jiao

Published 2019 in Social Science Research Network

ABSTRACT

This paper studies jointly optimal bailout policy and monetary policy in open economies. While the “fear of floating” literature favors that foreign currency liability exposure restricts countries’ incentives to devalue its currency, I document that countries with larger foreign currency liability/GDP ratio before financial crises underwent larger currency devaluation in crises. I build a quantitative open economy model with both nominal rigidities and financial frictions. Using the model, I show that in a world without bailout while currency mismatch cost is present, larger foreign currency liability before crises calls for smaller currency devaluation in crises, embracing the notion of “fear of floating”. The incorporation of optimal government bailout, whose cost needs to be financed by inflation tax, can overturn the above negative relationship between foreign currency liability and currency devaluation, delivering results consistent with the empirical findings. Finally, I use firm-level data to show that whether firms suffer from currency mismatch cost or not during crises hinges on their chance of obtaining a bailout. It supports that bailouts mitigate the negative currency mismatch cost due to currency devaluation. ∗I am deeply indebted to my thesis advisors Stephanie Schmitt-Grohé, Shang-Jin Wei, Patrick Bolton, Jesse Schreger, Martín Uribe for their constant guidance, support and encouragement. I am grateful to Yan Bai, Andres Drenik, Zhen Huo for detailed and extremely helpful discussions and suggestions. I thank Sakai Ando, Luigi Bocola, Tuo Chen, Feng Dong, David Dorn, Jonathan Eaton, Xiang Fang, Simon Gilchrist, Juan Carlos Hatchondo, Harrison Hong, Yoon Joo Jo, Réka Juhász, Kang Shi, Ryan Kim, Rishabh Kirpalani, Dirk Krueger, Jennifer La’O, Shu Lin, Qing Liu, Enrique Mendoza, Benjamin Moll, Frederic Mishkin, Seunghoon Na, Emi Nakamura, Serena Ng, Pablo Ottonello, Min Ouyang, B. Ravikumar, Bernard Salanié, Juan Sanchez, José Scheinkman, Michael Song, Jón Steinsson, Jian Wang, Neng Wang, Pengfei Wang, Yicheng Wang, David Weinstein, Yi Wen, Mike Woodford, Peifan Wu, Pierre Yared, Jing Zhou and seminar participants at various institutions for their invaluable comments. Part of this paper was written at the Federal Reserve Bank of St. Louis while I was a dissertation intern. I am very grateful for their hospitality. All errors are mine. †Dartmouth College and FISF, Fudan University ‡Email: yang.jiao@dartmouth.edu.

PUBLICATION RECORD

  • Publication year

    2019

  • Venue

    Social Science Research Network

  • Publication date

    Unknown publication date

  • Fields of study

    Not labeled

  • Identifiers
    DOI 10.2139/ssrn.3326204
  • External record

    Open on Semantic Scholar

  • Source metadata

    Semantic Scholar

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