Macroeconomic Policy with Illiquid Financial Markets

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

Financial markets play positive and negative roles in economic fluctuations. This project focuses on the latter roles and their impact on actual and optimal macroeconomic policy. Since emerging economies are particularly affected by financial underdevelopment and its consequences, they are both an object of study in themselves, and a good device to isolate the financial mechanisms that affect developed economies as well. Consequently, this project focuses on emerging economies but extracts more general lessons as well. The starting point of the project is a perspective where emerging economies are affected by two main forms of financial frictions. They have weak links with international financial markets and domestic financial markets are underdeveloped. The combination of these ingredients lead to occasional external crises, which are made more likely and severe by the equilibrium undervaluation of precautionary actions by domestic agents. Within this context the investigator asks and attempts to provide theoretical and empirical answers to questions such as: What is the appropriate monetary policy during crises and their prelude? How is the answer affected by the potential separation between domestic and international liquidity? To what extent and under which circumstances can monetary policy substitute for missing domestic insurance markets? How is this role affected by liability dollarization? Why does the latter persist long after inflation has subsided? What is behind the underinsurance problem of emerging economies? How is the standard political-economy analysis of central bank behavior affected by the presence of recurrent crises? What is the optimal exchange rate system for economies with underdeveloped financial markets?