Exchange Rate Volatility and the Credit Channel in Emerging Markets: A Vertical Perspective

Ricardo Caballero, Arvind Krishnamurthy

NBER Working Paper No. 10517
Issued in May 2004
NBER Program(s):   EFG   IFM

Firms in emerging markets are exposed to severe financial frictions and credit constraints, that are exacerbated by the sudden stop of capital inflows. Can monetary policy offset this external credit squeeze? We show that although this may be the case during moderate contractions (or in partial equilibrium), the expansionary effect of monetary policy vanishes during severe external crises. The exchange rate jumps to reduce the dollar value of domestic collateral until equilibrium in domestic financial markets is consistent with the external constraint. An expansionary monetary policy in this context raises the value of domestic collateral but it exacerbates the exchange rate depreciation (beyond the standard interest parity effect) and has little effect on aggregate activity. However there is a dynamic linkage between monetary policy and sudden stops. The anticipation of a dogged defense of the exchange rate worsens the consequences of sudden stops by distorting the private sector incentive to take precautions against these shocks. For similar general equilibrium reasons, dollarization of liabilities has limited impact during a sudden stop, but it has significant underinsurance consequences.

download in pdf format
   (346 K)

email paper

This paper is available as PDF (346 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w10517

Published: Ricardo Caballero & Arvind Krishnamurthy, 2005. "Exchange Rate Volatility and the Credit Channel in Emerging Markets: A Vertical Perspective," International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), May. citation courtesy of

Users who downloaded this paper also downloaded these:
Tornell and Westermann w9355 The Credit Channel in Middle Income Countries
Bernanke and Gertler w5146 Inside the Black Box: The Credit Channel of Monetary Policy Transmission
Ramey w4285 How Important is the Credit Channel in the Transmission of Monetary Policy?
Caballero and Krishnamurthy w11618 Bubbles and Capital Flow Volatility: Causes and Risk Management
Caballero and Krishnamurthy w8427 Smoothing Sudden Stops
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us