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International macroeconomics has been profoundly affected by the emerging market crises of the 1990's and the early part of this century. The crises have led economists to question conventional wisdom in many areas. For instance, the last few years have seen considerable revisionist thinking on the benefits of capital inflows, the primacy of fiscal imbalances in exchange rate crises, and the role of exchange rate adjustment in responding to external shocks.
Unfortunately, relatively little of this new literature has yet been absorbed into the language of policymaking. It is this deficit that the current paper attempts to correct. The authors have previously written a number of more technical papers exploring the effects of the "credit channel" in the macroeconomics of emerging market economies. This paper provides an exposition of the main messages of their papers in terms of a simple IS-LM-BP analysis, appealing to the universally known Mundell-Fleming apparatus. Unlike the Mundell-Fleming model, however, the present model does not lack microfoundations. But all the hard work is done in a lengthy appendix. The body of the paper is made extremely user-friendly, allowing readers to quickly absorb the main features of the model and then go on to do their own mental experiments within the framework. In terms of setting out an intuitive and elegant framework of analysis, the authors have been very successful.
While the main aim of the paper is to provide a textbook-friendly treatment of an open economy model with balance sheet constraints, a secondary aim is to evaluate if and how these constraints should alter our thinking about the benefits of exchange rate adjustment in emerging market economies.
The paper combines features from a number of different literatures. From the open economy macro literature, it uses a sticky-price intertemporal model with endogenous investment dynamics. From the credit channel literature, it introduces financial frictions in the form of a risk premium that is sensitive to net worth relative to liabilities. From the crisis literature, it emphasizes the importance of foreign currency liabilities. The result is an integrated macro model in which the effects of a negative external shock operating through the effects on the endogenous risk premium can be examined. The results parallel those in Bernanke, Gertler, and Gilchrist (1999)-shocks tend to get...