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What are the economic effects of an interest rate cut when an economy is in the midst of a financial crisis? Under what conditions will a cut stimulate output and employment, and raise welfare? Under what conditions will a cut have the opposite effects? We answer these questions in a general class of open economy models, where a financial crisis is modelled as a time when collateral constraints are suddenly binding. We find that when there are frictions in adjusting the level of output in the traded good sector and in adjusting the rate at which that output can be used in other parts of the economy, then a cut in the interest rate is most likely to result in a welfare-reducing fall in output and employment. When these frictions are absent, a cut in the interest rate improves asset positions and promotes a welfare-increasing economic expansion.

In recent years there has been considerable controversy over the appropriate monetary policy in the aftermath of a financial crisis. Some argue that the central bank should raise domestic interest rates to defend the currency and halt the flight of capital. Others argue that interest rate reductions are called for. They note that a country that has just experienced a financial crisis is typically sliding into a steep recession. They appeal to the widespread view that in developed economies like the US, central banks typically respond to situations like this by reducing interest rates. These authors urge the same medicine for emerging market economies in the wake of a financial crisis. They argue that to raise interest rates at such a time is a mistake, and is likely to make a bad situation even worse. One expositor of this view, Paul Krugman [20] (pp. 103–105) puts it this way: But when financial disaster struck Asia, the policies those countries followed in response were almost exactly the reverse of what the United States does in the face of a slump. Fiscal austerity was the order of the day; interest rates were increased, often to punitive levelsy: Why did these extremely clever men advocate policies for emerging market economies that would have been regarded as completely perverse if applied at home? We describe a framework that allows us to articulate the two views just described. The framework has two building blocks. First, we assume that to carry out production, firms require domestic working capital to hire labor and international working capital to purchase an imported intermediate input. Second, we adopt the asset market frictions formalized in the limited participation model as analyzed in [14,15,19,21]. The limited participation assumption has the consequence that an expansionary monetary action makes the domestic banking system relatively liquid and induces firms to hire more labor. To the extent that the imported intermediate input complements labor, the interest rate drop leads to the increased use of this factor too. This is in the spirit of the traditional liquidity channel emphasized in the closed economy literature, which stresses the positive effects of an interest rate cut on output. So, absent other considerations, the model rationalizes the Krugman view outlined above. Our model has an additional feature which may be particularly relevant during a crisis. We suppose that a crisis is a time when international loans must be collateralized by physical assets such as land and capital, and that this restriction is binding. To understand how collateral affects the monetary transmission mechanism in our model, it is useful to consider a simplified version of our collateral constraint expressed in units of the foreign currency: Q S KXR
z þ B: Here, B represents the stock of long-term external debt; z represents short-term external borrowing to finance a foreign intermediate input; R
represents the associated interest rate; K represents domestic physical assets like land and capital;Q is the value (in domestic currency units) of a unit of K; and S represents the nominal exchange rate. We suppose that under normal conditions, the collateral constraint is not binding, while it suddenly binds with the onset of a crisis. This may be because in normal times, output in addition to land and capital is acceptable as collateral. Then, in a crisis, the fraction of domestic assets accepted as collateral by foreigners suddenly falls.2 In any case, in our analysis we model the imposition of a binding collateral constraint as an exogenous, unforeseen event.3 We then compare the ensuing transition path of the economy under two scenarios. In the baseline scenario, the monetary authority does not adjust policy in response to the collateral shock. In the alternative scenario, the monetary authority reduces the domestic rate of interest relative to what it is in the baseline scenario. We find that in the baseline scenario, output and employment are low during the transition to the new steady state. The shadow-cost of international debt, B; is higher while the collateral constraint is binding, and the economy responds by increasing the current account and paying down the debt. In the new steady state the debt is reduced to the point where the collateral constraint is marginally non-binding. That is, the collateral constraint is satisfied as an equality, but with a zero multiplier. Although the transition path after a collateral shock is of independent interest because it captures key features of actual economies in the aftermath of a crisis, it is not the central focus of our analysis. Our key objective is to understand the impact on the transition of a cut in the interest rate. We study this by comparing the dynamic equilibrium of the economy under the baseline and alternative scenarios. We now briefly describe the results. In doing so, we make use of the fact that R
and K are held fixed throughout the paper. We also find it convenient in summarizing the results here to ignore the impact of the interest rate cut on B:4 Finally, in describing the intuition for the results we make use of our numerical finding that whenever there is a monetary policy-induced cut in the interest rate, there is a depreciation of thecurrency, i.e., a jump in S: Using these observations and the collateral constraint evaluated at equality, it is easy to see why it is that for some versions of our model an interest rate cut produces a contraction, and for others it produces an expansion. The contraction outcome is perhaps the easiest to understand. When S jumps, the left side of the collateral constraint falls. Supposing that Q does not jump very much, this means that the right side must be reduced, i.e., z must fall. Our assumption that the imported intermediate good is important in domestic employment and production ensures that a recession follows. In this outcome, the currency mismatch between assets and liabilities in the collateral constraint plays the central role. That an expansion outcome is possible is also easy to see. If the nominal interest rate cut succeeds in reducing the real interest rate used to discount future flows, then asset prices, Q; may in fact jump a substantial amount. Indeed, in closed economy settings when there are no currency mismatches in balance sheets, it is often considered the ‘natural’ outcome that a cut in the interest rate lifts asset prices and improves balance sheets. If the rise in Q is sufficiently strong to offset the nominal depreciation, then the left side of the collateral constraint is increased by the interest rate cut. In this case, there is room in the collateral constraint for z to go up, and for domestic production to rise. The above discussion suggests that the contraction outcome is most likely in economies where an increase in z does not lead to a substantial increase in Q; the value of productive capital and land. Two features promote this possibility in our model environment. The first occurs if increases in z encounter strong decreasing returns in production, and complementary factors of production cannot be brought in to offset this. The second occurs if there is little substitutability between traded and non-traded goods in the production of final goods. By inhibiting the ability of the economy to effectively exploit increases in z; these two features reduce the likelihood that an increase in z is associated with a substantial rise in Q: We find that when these frictions are not present, then an interest rate cut tends to be associated with the expansion outcome. The role of asset prices in propagating shocks is a topic that is of independent interest. The existing literature focuses on the role of asset prices in magnifying and propagating the effects of shocks.5 We obtain the magnification effect here too, in the version of the model that implies the expansion outcome. In that model, the response of output and employment to an interest rate cut is the same sign and stronger than it is when the collateral constraint is ignored altogether. Interestingly, in the version of the model that implies the contraction outcome, the collateral constraint actually has the effect of changing the sign of the economy’s response.6 The organization of the paper is as follows. The next section presents our general model. Section 2 presents a version of the model simplified by the assumption thatthe stock of external long-term debt is held constant. The advantage of this simplification is that the model can be studied analytically. The insights that are obtained from this are useful for understanding the more relevant version of the model, in which the long-term external debt is determined endogenously. Numerical methods are used to study this version of the model in the third section of the paper. The final section concludes.

We analyzed a small open economy model in which firms require two types of working capital: domestic currency to hire domestic inputs and foreign currency to finance imports of an intermediate input. We adopt a reduced form model of a financial crisis, and ask what is the economic impact of a cut in the domestic rate of interest at such a time. We model a financial crisis as a time when collateral constraints on borrowing are imposed and are binding. Our notion of a ‘financial crisis’ corresponds to what some might think of as a ‘credit crunch’. In our model, application of binding collateral constraints causes the economy to run a current account surplus and bring its debt down to the steady state in whichFig. 13. Effect on transition of policy cut in interest rate, expansion scenario model (Cont’d). Notes: % dev from baseline—percent deviation from baseline path of constant money growth; dev from baseline— deviation from baseline path (percentage points).the collateral constraint is marginally non-binding. During the transition, the collateral constraint limits the amount of borrowing that firms can do, and so leads to a reduction in output and employment. In addition, asset values fall with the slowdown in activity, and real and nominal exchange rates depreciate and overshoot with the onset of the crisis. These features of the transition dynamics in our model correspond—at least qualitatively—with what was observed in the Asian crises that began in late 1997. We believe that this justifies taking our reduced form model of afinancial crisis seriously, as a laboratory for studying the economic effects of a cut in the domestic interest rate in the aftermath of a financial crisis. To understand our analysis of the effects of the interest rate cut, it is sufficient to keep in mind firms’ collateral constraint: the requirement that the value of their assets be no less than the value of their liabilities. We model the former as consisting of productive assets such as land and capital in the domestic economy. Also, most of firms’ liabilities take the form of international debt. Our framework captures the tensions emphasized in the literature that are created by operation of this collateral constraint. First, an interest rate cut engineered by the central bank produces a nominal exchange rate depreciation in our model. Other things the same, this tightens the collateral constraint by producing a fall in the value of the domestic assets of the firm, while not affecting the value of international liabilities. This effect arises from the widely discussed mismatch in the currency denomination of assets and liabilities. This effect could be compounded if in addition to a nominal depreciation, there is also a real depreciation. Second, an interest rate cut can also alleviate the collateral constraint by pushing up asset values. We find that the first scenario—the one in which currency mismatch problems cause an interest rate cut to produce a contraction—is more likely when there are limitations in how flexibly the economy can exploit an increase in the quantity of the intermediate good. The second scenario—the one in which an interest rate cut produces an expansion by inflating asset values—is more likely when these limitations are not present. We conclude that resolving the debate over the effects of an interest rate cut in the aftermath of a financial crisis requires understanding how much short-run flexibility there is in the economy. We suspect that there is relatively little such flexibility, at least in the short run, so that the contraction scenario may be the most plausible one.