Digression:
http://delong.typepad.com/delongslides/2008/04/april-16-2008-l.html
Start with a version of our consensus sticky-price international short-run business cycle model, in "difference" form:
Things to note about this version:
- The impact of financial crisis: large losses by banks and non-bank banks that reduce their capital and thus increase space for moral hazard, and the absence of track records as good investment-pickers that give savers confidence in intermediaries drive big wedges between the interest rates the Fed controls ("r") and the interest rates relevant for investment spending.
- The dependence of the degree of financial crisis on the jump in the value of foreign curency--the change in the exchange rate--through this parameter phi which reflects the degree of currency mismatch in financial-sector positions..
- The effect of increased government spending (or perhaps it should be budget deficits?) in eroding foreign exchange-speculator confidence in the domestic currency.
So now what are the consequences of a sudden, outside collapse in confidence in the currency? We do the math:
Things to note:
- The switch from r to e as the central bank's control variable
- Nothing bad has happened to business confidence here at home--yet we have a depression
- The sign of the coefficient on government purchases G is uncertain
- Digression on the IMF, and on Herbert Hoover...
- The fact that there are no good short-run options
Needed: the analogue of "stage III" policies:
- In a domestic financial crisis, the central bank
- swaps out safe for risky securities to boost the prices of risky assets
- can ultimately print cash and swap it out for risky securities
- people want cash, and trust the government, and the government can print it (it may create an inflation problem, but the government can print it and can maintain full employment)
- In an international crisis, the cash people want is safe, foreign assets--not something the central bank can print
- But the IMF can...
A new exchange rate determination equation:
- The role of the IMF (and other foreign central bank-like organizations)
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