The case for flexilbe exchange rates in a great recession

Abstract

We analyze macroeconomic stabilization in a small open economy which faces a large recession in the rest of the world. We show analytically that for the economy to remain isolated from the external shock, the exchange rate must depreciate not only to offset the collapse in external demand, but also to decouple domestic prices from the deflation in the rest of the world. If monetary policy becomes constrained by the zero lower bound, the scope of exchange rate depreciation is limited and the economy is no longer isolated from the shock. Still in this case there is a /benign coincidence": government spending is particularly effective in stabilizing economic activity. Under fixed exchange rates, instead, the impact of external shock is particularly severe and the effectiveness of fiscal policy reduced.