Essays on balance sheets, exchange rate policy, and macroeconomic performance

This dissertation studies the role played by financial frictions and exchange rate regimes in the propagation of external shocks in small open economies. The first essay provides a framework to analyze the role of credit constraints and debt denomination in the generation and amplification of macroeconomic instability in an open economy context. Entrepreneurs whose net worth is not enough to finance their desired investment have to pay a premium above the risk-free interest rate to obtain external funds. Additionally, a foreign good is used as an input in the production of the capital good, and debt are denominated in terms of the foreign good. Real exchange rate depreciations generate an increase in the cost of producing capital and a reduction in the net worth of entrepreneurs due to the debt denomination. Therefore, recessionary effects can be deepened.; The second essay, a joint work with Roberto Chang and Andrés Velasco, explores the relation among exchange rates, balance sheets, and macroeconomic outcomes in a small open economy. Because liabilities are “dollarized,” a real devaluation can have detrimental effects on one component of entrepreneurial net worth, which in turn constrains investment due to financial frictions. But a real depreciation can also expand home output and the return to domestic investment, which is another component of net worth. We show that the impact of an adverse foreign shock can be strongly magnified by the balance sheet effect of the associated real devaluation. But the fall in output, employment, and investment is stronger under fixed exchange rates than under flexible rates.; The third essay uses a structural VAR approach to examine the dynamic response of domestic variables to world interest rate and emerging markets spread shocks. The main conclusions of the paper indicate that, defining monetary policy independence as the ability to manage lower increases in interest rate when facing external shocks, floaters exhibit systematic lower responses in interest rates when facing shock to the world interest rate and to the emerging markets spread. Moreover, in most of the cases under analysis, the contraction in output is consistently higher for the currency-board countries.