Currency crises and monetary policy in an economy with credit constraints

This paper presents a simple model of currency crises which is driven by th e interplay between the credit constraints of private domestic firms and th e existence of nominal price rigidities. The possibility of multiple equili bria, including a 'currency crisis' equilibrium with low output and a depre ciated domestic currency, results from the following mechanism: If nominal prices are 'sticky', a currency depreciation leads to an increase in the fo reign currency debt repayment obligations of firms, and thus to a fall in t heir profits; this reduces firms' borrowing capacity and therefore investme nt and output in a credit-constrained economy, which in turn reduces the de mand for the domestic currency and leads to a depreciation. We examine the impact of various shocks, including productivity, fiscal, or expectational shocks. We then analyze the optimal monetary policy to prevent or solve cur rency crises. We also argue that currency crises can occur both under fixed and flexible exchange rate regimes as the primary source of crises is the deteriorating balance sheet of private firms. (C) 2001 Elsevier Science B.V . All rights reserved.