Optimal Monetary Policy in a 'Sudden Stop'
In the wake of the 1997-98 financial crises, interest rates in Asia were raised immediately, and then reduced sharply. We describe an environment in which this is the optimal monetary policy. The optimality of the immediate rise in the interest rate is an example of the theory of the second best: although high interest rates introduce an inefficiency wedge into the labor market, they are nevertheless welfare improving because they mitigate distortions due to binding collateral constraints. Over time, as various real frictions wear off and the collateral constraint is less binding, the familiar Friedman forces dominate, and interest rates are optimally set as low as possible.
Braggion thanks the European Central Bank and the International Monetary Fund for their hospitality. Christiano is grateful for the financial support of a National Science Foundation. The authors are grateful for the advice and comments of Klaus Adam, Martin Eichenbaum, Alejandro Izequierdo, Ken Judd, Narayana Kocherlakota, Juan Carlos Rodriguez, Andrew Scott, Jaume Ventura and Michael Woodford. The results reported in this paper do not necessarily reflect the opinion of the International Monetary Fund or the National Bureau of Economic Research.
Braggion, Fabio & Christiano, Lawrence J. & Roldos, Jorge, 2009. "Optimal monetary policy in a [`]sudden stop'," Journal of Monetary Economics, Elsevier, vol. 56(4), pages 582-595, May. citation courtesy of