Monetary Policy During Currency Crisis in Developing Countries

<p>The research deals with the topic of a currency crisis caused by an unpredicted shock of exchange rate in developing countries. The study&rsquo;s intention is to examine a general equilibrium currency crisis model of the &lsquo;third generation&rsquo; of &nbsp;Ph. Aghion, Ph. Bacchetta, A. Banerjee, in which the possibility of currency crises is driven by the interplay between private firms&rsquo; credit constraints and nominal price rigidities; to build a model of currency crisis caused by the currency mismatch in balance of&nbsp; domestic commercial banks and to conduct policy analysis. The study throws light on the such cause of financial crises in emerging markets as international illiquidity and moral hazard.</p><p>The main study question is: what monetary policy will help the economy to overcome the crisis caused by the negative shock of the exchange rate based on the availability of foreign exchange risk at the bank level. The aim of the study is to analyse the effective combination of instruments of monetary policy to pursue during currency crises caused by the negative exchange rate shock in developing countries. The tasks of the study are the following:</p><p>&bull; To build a model of currency crises of the third generation (based on the model of Aghion, Bacchetta, Banerjee), to examine in more detail the banking sector (the balance of the commercial bank, currency mismatch of assets and liabilities, the problem of moral hazard);</p><p>&bull; To find out what the effective monetary policy should be like in conditions of the currency crisis caused by the negative exchange rate shock.</p><p>The conclusion was obtained that in the case of the negative exchange rate shock, monetary policy could positively influence the output by reducing reserve requirements, while the discount window rate has no effect on the output, and at the same time it influences the exchange rate and capital flows: when the discount window rate grows, if commercial banks have unlimited access to foreign credits, the volume of attracted funds from abroad increases, and due to capital inflows domestic currency will rise in price. The most effective in terms of impact on the output measure of monetary policy during the currency crisis in the built model is changing the required reserves ratio. The considered model also shows that a reduction of the required reserves ratio and increase of the discount rate allows the central bank to increase capital inflows, what partly smoothes out the effects of the negative exchange rate shock.</p>