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Exchange Rate Crises (Chap. 9) (assumptions in a small open economy…
Exchange Rate Crises (Chap. 9)
exchange rate crisis: depreciation of 10%-15% after a peg breaks (in advanced markets)
an exchange rate crisis in an emerging market is around 20%-5%
banking crisis: when banks declare bankruptcy after becoming insolvent, occurs in the PRIVATE sector
default crisis: gov defaults and is unable to pay principle or interest on debts, occurs in PUBLIC sector
crises are likely to happen in pairs (twin crises) or all three at once (triple crises)
assumptions in a small open economy attempting to peg to a foreign currency
assume home currency is pesos, foreign currency is the US dollar
central bank controls money supply (M) by buying and selling assets in exchange for cash
central bank trades domestic bonds in pesos, and foreign assets in dollars
assume the peg is credible, stable foreign price level, short run price is sticky
do not use a financial system
domestic credit: loaning money to a domestic economy
reserves: quantity of dollars of foreign exchange reserves
central bank balance sheet
assets = change in domestic credit (B) + change in reserves (R)
floating line: central balance sheet has no reserves
fixed line: money supply is at the level necessary to maintain the peg
currency board: fixed exchange rate that operates w reserves equal to 100% of the money supply
money supply issued by central bank (M) = liabilities
Argentina Tequila Crisis
banking crisis 1995: higher interest rates, central bank extended loans, reserves fell
IMF was lenient, fearing a global financial crisis, IMF resumed lending
patriotic bond: loan given by the IMF to replenish reserves and sent up a fund to salvage insolvent commercial banks
two types of exchange rate crises
1) domestic credit is expanding, central bank is pushed up the fixed line until reserves run out, currency floats, money supply grows w/o limit, exchange rate depreciates
2) no long-run tendency for money supply to grow, short-run temptation to expand money supply, leads to a temporarily lower interest rate and a temporarily depreciated exchange rate
first generation crisis model: inconsistent fiscal policies in a country w a fixed exchange rate
key points
exchange rate crisis: large and sudden depreciation, brings an end to a fixed exchange rate regime; very common, lasts a few years, can affect all types of countries
to avoid a crisis, central bank w fixed exchange rate regime must peg to the exchange rate
need foreign currency reserves, which can be bought or sold in the forex market at the fixed rate
if the money demand rises (falls) holding domestic credit fixed, reserves rise (fall) by the same amount
if domestic credit rises (falls), holding money demand fixed, reserves fall (rise) and money supply is unchanged, AKA sterilization
first generation crisis: domestic credit grows at a constant rate forever, reserves drain, money supply continues to grow, causing inflation and depreciation
second gen crisis: commitment to the peg is contingent; floating and expansionary policies will be use if the peg is causing high costs to the economy