Exchange-rate-based stabilization syndrome: Credible disinflation, capital inflows, and the domestic banking system

Interactions between the banking sector and an open capital account are investigated as rationalizations for the empirical regularities that characterize disinflation programs anchored by fixing the exchange rate. Financial intermediation and bank money creation are formalized within a dynamic general equilibrium model with multiple monetary aggregates and a financial system characterized by imperfections such as incomplete markets and an externality in the bank lending process. Financial markets are incomplete in the sense that bank loans are the sole source of external finance for nonfinancial firms, and bank deposits are the only form of household savings. The bank lending externality arises because individual banks do not internalize the effect of their lending decisions on the quality of information about potential borrowers received by other banks, and therefore extend more credit than they otherwise would.; Simulation of the model economy's equilibrium dynamics shows that an initial increase in the supply of loanable funds resulting from remonetization of the economy in the wake of disinflation can translate into a further rapid expansion of bank credit financed by short-term capital inflows. A credit-driven boom results, accompanied by a currency overvaluation and current account deficits. Together, these generate systemic financial fragilities and make the economy vulnerable to a small shock that can trigger banking and balance-of-payment crises. The model is thus capable of replicating the empirical regularities observed in exchange-rate-based stabilization programs without relying on imperfect credibility or nominal rigidities.; Accounting for the role of the banking sector can help to explain why even well-designed exchange-rate-based stabilization programs may set in motion a dynamic process that can lead to a financial crisis and the program's collapse. The policy implication for developing countries is that the authorities should pay attention not only to the design of monetary and exchange rate policies but also to the framework of monetary and financial institutions. The results of the study suggest that diversifying the source of investment finance away from banks and reducing externalities associated with bank lending may be essential preconditions for implementing successful stabilization programs.