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In the wake of the 1997–98 financial crises, interest rates in Asia were raised immediately, and then reduced sharply. We describe an environment in which this is the optimal monetary policy. The optimality of the immediate rise in the interest rate is an example of the theory of the second best: although high interest rates introduce an inefficiency wedge into the labor market, they are nevertheless welfare improving because they mitigate distortions due to binding collateral constraints. Over time, as the collateral constraint is less binding, the familiar Friedman forces dominate, and interest rates are optimally set as low as possible.

The Asian financial crises of 1997–98 triggered a sharp debate over the appropriate response of policy to a financial crisis. The hallmark of the crises was a ‘sudden stop’ (Calvo, 1998): capital inflows turned into outflows and output suddenly collapsed. Some argued, appealing to the traditional monetary transmission mechanism, that a cut in the interest rate was required to slow or reverse the drop in output. Others argued that because of currency mismatches in balance sheets, the exchange rate depreciation associated with a cut in the interest rate might exacerbate the crisis. They argued for an increase in interest rates. Interestingly, a look at the data indicates that both pieces of advice were followed in practice. Fig. 1 shows what happened to short-term interest rates in each of four Asian crisis countries. Initially they rose sharply. Within six months or so, the policy was reversed and interest rates were ultimately driven to below their pre-crisis levels. A casual observer might infer that policy was simply erratic, with policymakers trying out different advice at different times.We argue that the observed policy may have served a single coherent purpose. We describe a model in which 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.1 We characterize a financial crisis as a time when collateral constraints bind unexpectedly and are expected to remain in place permanently. Real frictions in our model have the consequence that in the immediate aftermath of the collateral shock, the monetary transmission mechanism is the reverse of what it would otherwise be. In particular, a rise in the interest rate increases economic activity and welfare. Over time, as the real frictions wear off, the monetary transmission mechanism has the traditional long run property that low interest rates stimulate output and raise welfare. Our model is a version of the standard small, tradable/non-tradable goods open economy model. The real friction is that labor in the tradeable sector is chosen prior to the realization of the current period shock.2 Thus, when the financial shock occurs the allocation of labor to the tradeable sector cannot respond immediately, although it can respond in subsequent periods. We adopt two financial frictions. First, to capture the non-neutrality of money our model incorporates the portfolio allocation friction in the limited participation model.3 In the absence of collateral constraints, our model reproduces the traditional monetary transmission mechanism: when the domestic monetary authority expands the money supply, the liquidity of the banking system increases and interest rates fall, leading to an expansion in output and a depreciation of the exchange rate. Second, we assume firms make use of labor and a foreign intermediate input, and that these must be financed in advance. The collateral constraint applies to the loans undertaken to purchase the foreign intermediate input. Our collateral constraint captures the balance sheet mismatch problems often emphasized in the context of currency crises, because liabilities are denominated in foreign currency while assets are denominated in domestic currency.4 The surprising feature of optimal policy in our model is that the domestic nominal interest rate rises sharply in the period of the collateral shock. That this policy response is optimal is a consequence of the interaction of the financial and real frictions. A rise in the interest rate acts like a tax on the employment of labor in the non-traded good sector, and raises the marginal cost of production in that sector. Other things the same, this slows down economic activity. However, when the collateral constraint is binding another effect dominates. Because the employment of labor by firms in the traded sector is predetermined in the period of the shock, the interest rate rise does not increase the marginal cost of production in that sector. With the marginal cost of non-traded goods rising relative to the marginal cost of traded goods, the relative price of non-traded goods increases. Other things the same, this increase raises the traded-good value of the physical capital stock in the non-traded sector. Because this capital is part of the collateral used to back loans needed to import intermediate goods, the collateral constraint is relaxed. Imports of intermediate goods increase and the production of tradeable goods expands. Because tradeable and non-tradeable goods are complements in domestic production, the demand for non-tradables increases and overall economic activity expands. Welfare is increased by the high interest rate, despite the fact that it introduces a distortionary wedge in the labor market. The reason welfare increases is that the policy has the effect of sharply reducing another wedge, the one that is associated with the collateral constraint. The mechanism by which the higher interest rate produces higher output is the novel aspect of our paper.5 Our monetary policy analysis occurs in the context of a sudden stop triggered by a collateral shock. The economic effects of this shock begin with an increase in the shadow cost of foreign borrowing, since debt now limits the ability of firms to purchase foreign intermediate inputs. Because intermediate goods are crucial for domestic production, the decline in these inputs results in an aggregate output drop. In addition, the sharp rise in the shadow cost of debt induces agents to pay down that debt by running a current account surplus. This process continues until the debt falls to the point where the collateral constraint is non-binding and the economy is in a new steady state. The role of monetary policy in the wake of a collateral shock is to affect the nature of the transitory dynamics triggered by the shock. A welfare-maximizing monetary policy raises the interest rate sharply in the immediate aftermath of a shock and thereby resists (though does not reverse) the fall in nominal and real exchange rates, output, employment and consumption, caused by the collateral shock. We compare the dynamic behavior of the variables in the model with data drawn from the Korean crisis. Qualitatively, the model reproduces the Korean experience reasonably well. In particular, the model reproduces the observed transitory rise in the current account, and fall of real quantities such as employment, consumption and output. The model also captures the evolution of asset prices, the real and nominal exchange rate and the behavior of the interest rate. Taken together, this evidence suggests that our model may provide a useful interpretation of the apparently erratic behavior of monetary policy exhibited in Fig. 1. The model does have quantitative empirical shortcomings. Although it captures the direction of movement in the current account, it understates the magnitude. We suspect that this reflects the absence of physical investment in the model. A reduction in investment provides agents with another margin from which to draw resources that can be used to pay off the international debt. Also, though the inflation response of the model to the financial shock matches qualitatively, it overstates its magnitude. In addition, the model cannot account for the drop in labor productivity observed in the Korean financial crisis. The latter two shortcomings are classic problems in the analysis of economic fluctuations and are the subject of much ongoing research. The paper is organized as follows. Section 2 provides a detailed account of South Korea's experience during the financial crisis. Section 3 presents an empirical defense of the main assumptions of the model. The fourth section presents our model. Section 5 discusses model calibration and Section 6 presents our simulation results. Second 7 concludes.

In this paper we studied the optimal monetary policy response to a financial crisis of the kind experienced Korea and other Asian economies in 1997–98. These crises, as many other emerging market crises, were characterized by a sudden reversal in capital inflows. Using a particular open economy model with collateral constraints, we found that the optimal monetary response to such a crisis involves an initial increase in interest rates, followed by a relatively sharp reduction. Interestingly, this is the policy that was actually followed. In our model, increasing the interest rate is very much like raising a tax.20 As a result, our analysis may also yield insight into the episodes of ‘expansionary fiscal consolidations’ emphasized by a large literature initiated by Giavazzi and Pagano (1990). For example, Perotti (1999) presents some evidence that large tax increases are more likely to stimulate the economy when levels of debt are high. Based on this evidence, he argues that a model is required in which the response of the economy to tax changes depends on the initial conditions, such as the level of debt. Our model is very much in this spirit. At a methodological level, this paper adds to the literature that studies the impact of financial frictions on the monetary transmission mechanism. In traditional models, financial frictions have the effect of magnifying—through an ‘accelerator effect’—the effects of monetary actions, without changing their sign. In this model we have shown that financial frictions could actually have a ‘reverse accelerator effect’, in that they reverse the sign of the effect of a monetary action.