In response to my post “How the Original Sin of Borrowing in a Foreign Currency Can Reduce the Effectiveness of Monetary Policy for Both the Borrowing and Lending Country” I received an interesting email from MIT graduate student Olivier Wang that led to the exchange below. (You will need to read “How the Original Sin of Borrowing in a Foreign Currency Can Reduce the Effectiveness of Monetary Policy for Both the Borrowing and Lending Country” first in order to understand this exchange. I am grateful to Olivier for permission to share this with you:

Olivier: I am a graduate student at MIT and I’ve been enjoying your blog a lot, so thank you! I’ve worked on some of the issues in your post on foreign currency borrowing. Whether a “depreciation makes debts look larger” depends on the pass-through of exchange rate to import prices. In the extreme but most studied case where prices are sticky in the foreign exporters’ currency and the depreciation is fully passed through (an assumption known as PCP), the real external debt burden stays invariant and original sin does not prevent monetary policy from stimulating the economy.

Another popular way to model contractionary depreciations has been to add a financial accelerator. If firms’ investments is constrained by their net worth, the depreciation will hurt the net worth of the currency mismatched firms and this effect might dominate the boost to net worth induced by the expenditure switching of consumers towards domestic goods.

Miles: Thanks for letting me know about this. I confess I don’t understand this:

One detail I emphasize there is that whether a “depreciation makes debts look larger” depends on the pass-through of exchange rate to import prices. In the extreme but most studied case where prices are sticky in the foreign exporters’ currency and the depreciation is fully passed through (an assumption known as PCP), the real external debt burden stays invariant and original sin does not prevent monetary policy from stimulating the economy.

If the thing I (the debtor-in-foreign-currency country) am exporting has a world price, then I effectively have another asset that goes up in value relative to my own currency when my currency depreciates. But if it isn’t that, I don’t understand the paragraph above at all. Could you help me out by trying to explain this to me a little more?I do understand the financial accelerator better. I should mention that sometimes wealth is not just wealth but also collateral.

Olivier: Apologies for being too cryptic. Suppose that as a consequence of an interest rate decrease, the Chilean exchange rate depreciates from 1 to 1.1 pesos per dollar. If I am a Chilean firm or household owing $100 abroad, my debt will indeed jump to 110 pesos, making me cut back on investment or consumption. But if the price of the foreign goods that I import (such imports being why I have this dollar debt in the first place) are set in dollars and don’t move much in the short run, their peso price also jumps by 10%, which makes me substitute towards domestic varieties of the same goods or simply buy different domestic goods (whose peso prices are also fixed in the short-run).

As everybody in the country does so, my own peso income also increases, and under these extreme pricing assumptions, the general equilibrium feedback and the reevaluation of the foreign currency debt net out, and the interest rate cut remains expansionary. Still, the economy is less stimulated than if the debt were denominated in pesos, as in this case an unexpected depreciation would directly transfer wealth from foreign creditors to domestic debtors.

If however the sticky price of half of my imported goods is set in pesos, the depreciation will only raise the price of the basket of imports by 5%, and the debt reevaluation will dominate. Taking this into account, the Chilean central bank might decide not to cut rates so much in response to domestic shocks.

All this is on top of the increased peso revenue from my exports that you mention, and which would be the most relevant effect in the case of Chile.

Miles: Thanks, Olivier! So a substitution effect toward domestic goods raises aggregate demand. I missed that.