After the breakdown of aggregate investment observed after the 1997-98 East Asian crisis, in almost all countries which suffered from sharp nominal devaluations, academicians and policymakers have engaged in a hot debate about the adequate monetary policy strategy against a speculative attack on the domestic currency. By means of a simple currency crisis model based on Proano, Flaschel and Semmler (2005), this paper shows how an increase in the domestic interest rate by the central bank, as a response to a currency run on the domestic currency, can significantly affect the aggregate demand by depressing the investment of the subsector of domestic firms which are not indebted in foreign currency.

As the 1997-1998 East Asian crisis demonstrated, the existence in a country of a large fraction of firms indebted in foreign currency, complicates to a significant extent, the reaction of monetary policy to a currency run on the domestic currency, due to the prospective negative effects which each alternative represents for the performance of the economy. On the one hand, a tightening of the monetary conditions (intended to defend the prevailing nominal exchange rate level, and so to protect the share of the domestic corporate sector indebted in foreign currency) is likely to hurt the domestic economy through the traditional credit channel. Additionally, since the borrowing of additional foreign funds becomes more difficult during episodes of financial turmoil,1 an increase in the domestic interest rate (in order to make domestic bonds more attractive, and hence reduce the pressure in the foreign exchange market) is considered by the majority of economists as the most appropriate, practicable and sustainable way to defend the prevailing exchange rate. On the other hand, a loose monetary policy can lead to a sharp devaluation of the domestic currency, and to the occurrence of a currency mismatch between the value of assets and liabilities. This is, in turn, likely to cause a credit crunch and a sharp decline in aggregate investment (the balance sheet channel), as discussed by Mishkin (1996), Krugman (2000a), and Kaminsky and Reinhart (2002).

Unfortunately, a theoretical consensus concerning the right monetary policy strategy to be followed, has still not been reached. In Aghion et al. (2001), for example, a restrictive monetary policy is the optimal response on the onset of a currency crisis, only if the credit multiplier depends on the ‘real’ interest rate. If on the contrary, this variable depends on the ‘nominal’ interest rate, then a loose monetary policy is the better alternative. Christiano et al. (2004), also deliver, within a utility maximizing general equilibrium framework, an ambiguous result after which the final effect of an interest rate cut by the domestic monetary authorities—whether expansionary or contractionary—depends on the flexibility of the productive sector (of intermediate and final goods), towards the activation of borrowing constraints of external funds used to finance the purchase of foreign intermediate goods. Braggion et al. (2005), on the other hand, focus on the optimal ‘timing’ of nominal interest rate increases and cuts. These authors summarize the results of their model in the following way: “the optimal response to a financial crisis is an initial sharp rise in the interest rate, followed by a fall to below pre-crisis levels”

Currency Crises and Monetary Policy in Economies with Partial Dollarization of Liabilities, domestic firms, domestic currency, nominal devaluations, academicians and policymakers, domestic corporate sector, aggregate investment, monetary conditions, productive sector, foreign intermediate goods.