The Balance Sheet Effect and Monetary Policy

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In this project I started to examine and analyze the Balance Sheet Effect in detail which has been emphasized as the causal factor of currency crises in the recent literature, with an aim to find out under what situations and mechanisms crises erupt, and to propose what kid of monetary policy should be appropriate to deal with crises.First, I closely examined the so-called the first generation model and the second generation models. and confirmed the limitations inherent to those models, and then examined the third generation model. In the latter models, with full recognition of the limitations and deficiencies of the former two models, the moral hazard problems on the financial institutions, the rescue problems on the government side fragility of the financial institutions, deterioration of the balance sheet on the firms, etc. have been emphasized as causal factors of crises.The Balance Sheet Effects were examined by scrutinize empirical researches for six Latin American countries (Co … More lumbia, Brazil, Peru, Chile, Mexico, and Argentina). Due to data restrictions I found that it was not an easy task to establish the existence of the Balance Sheet. Effects in those countries.With the Balance Sheet Effects it is likely that a currency crisis erupts. Once the crisis erupts, and if the monetary authorities adopt a restrictive policy as a counter measure, two contradictory views have been offered : one is the so-called orthodox view, in which the restrictive policy has an intended effect to bring the economy back to the recover process and the other is the perverse view, in which such a policy makes the economy further away from recovery and even worse. I examined which view is correct and under what conditions the perverse view is likely within a simple, intertemporal optimization model by an interaction between the real sector and the asset sector. Due to several exogenous shocks I clarified that under certain conditions a crisis may be likely with an excessive depreciation of the exchange rate and a large fall in the output. Furthermore, in those crisis situations, I could show that there are cases in which the perverse view predicts if the monetary authorities adopt restrictive monetary policy. Less