Exchange Rate Crises

Roberto Chang

Rutgers University

Introduction

• Financial crises and currency crashes have been a policy concern for a very long time

• However, economic theories that may explain them are relatively recent

• Key Material: chapter 9 of FT

What do Exchange Rate Crises Look Like?

• “Crises” refer to sudden changes in some variables (reserves, prices) and abandonment of some policies

• While dramatic, crises episodes do not seem to be completely chaotic

• The first economic model : Krugman 1979

“First Generation” Models

Basic Example (Flood-Garber)

• Small Open Economy

• Domestic Residents may hold domestic currency, and domestic and foreign bonds

• Initially, the central bank pegs the exchange rate at some value S

Assumptions on the Economy

• Money Demand Equation:

M(t)/P(t) = a0 – a1i(t)

• Purchasing Power Parity:P(t) = P*(t)S(t) = S(t)

• Uncovered Interest Parity: i(t) = i* + [∆S(t)/S(t)]

(∆S(t) = dS(t)/dt)

While the exchange rate is fixed at S, i(t) = i* (by UIP)

and M(t)/P(t) = M(t)/S(t)

= M(t)/S

= a0 – a1i*

the nominal demand for money M(t) is fixed at M(t) = S(a0 – a1i*)

Remark

• The implications that in a fixed exchange rate the nominal demand for money is

M(t) = S(a0 – a1i*)

are discussed in FT

• For example, FT asks what happens if a0 falls, say.

Central Bank Behavior

• The central bank pegs the exchange rate by standing ready to sell its reserves, R(t), for domestic currency at the fixed rate S

• This policy is feasible only if reserves are nonnegative. If reserves fall to zero, the central bank must abandon the peg. Then it is assumed that the currency floats.

The Central Bank Balance Sheet

• CB balance sheet:

M(t) = R(t) + D(t)

where D(t): Central Bank credit to the rest of the economy

• Observe that, if reserves are zero, M(t) = D(t) (central bank always finances government needs)

The Central Bank Balance Sheet: Implications

FT emphasize some implications of the CB balance sheet:

M(t) = R(t) + D(t)

1.For given M(t), an increase in CB credit must result in a fall in reserves

2.FX Intervention and Sterilization

3.Why would D(t) change?

4.Currency Board Systems

Evolution of Government Credit

• Krugman and Flood-Garber assumed that government credit must always increase due to fiscal dominance: for all t,

∆D(t) = μ > 0

(Hence D(t) = D(0) + μt)

Key Problem

• Fixed exchange rate and central bank credit policy are inconsistent. To see this, recall

M(t) = R(t) + D(t)

• If the exchange rate is fixed, i = i*, so M(t) = S(a0 – a1i*)

• D grows then R must be falling. But then R will be exhausted at some point

Exchange Rate Crises

• Krugman’s crucial insight: reserves will not fall smoothly to zero, but they will be exhausted in a final attack

• (Why? If reserves fell to zero smoothly, then at the time of reserve exhaustion, call it T, the exchange rate would depreciate abruptly. But then everybody would attempt to get rid of domestic currency before T to avoid capital losses.)

Figure 9.12 Two Types of Exchange Rate CrisisFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.13 An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Myopic CaseFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.13 (a) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Myopic CaseFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.13 (b) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Myopic CaseFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.13 (c) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Myopic CaseFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.14 An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Perfect-Foresight CaseFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.14 (a) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Perfect-Foresight CaseFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.14 (b) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Perfect-Foresight CaseFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.14 (c) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Perfect-Foresight CaseFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.15 A Crisis in Peru: The Inconsistent Policies of the García AdministrationFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Noteworthy Aspects

• Reserves fall smoothly for a while, then are exhausted in a final attack

• Crises are predictable: the time of the attack and the fall in reserves are known in advance

• Key driving force: inconsistent policy

Some Weaknesses

• Obstfeld 1994: in practice, some governments seemed to be able to borrow the reserves they need

• Abandonment of a fixed parity seems to be a government decision (ERM 1992 crises)

• This led to “second generation” models (driven by contingent policy)

Figure 9.16 (a) Contingent Commitments and the Cost of Maintaining a PegFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.16 (b) Contingent Commitments and the Cost of Maintaining a PegFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.16 (c) Contingent Commitments and the Cost of Maintaining a PegFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Figure 9.17 Contingent Policies and Multiple EquilibriaFeenstra and Taylor: International Macroeconomics, Second EditionCopyright © 2012 by Worth Publishers

Remark: Risk Premia in Advanced and Emerging Markets

Uncovered interest parity (UIP) requires that the domestic return (the interest rate on home bank deposits) equal the foreign interest rate plus the expected rate of depreciation of the home currency.

When additional risks affect home bank deposits, a risk premium is added to compensate investors for the perceived risk of holding a home domestic currency deposit.

premiums)risk no are thereand credible is peg if zero to(equalspread rateInterest

peso theofondepreciati

of rate Expected

peso/$

peso/$

rateinterestDollar

*

rateinterest

Pesopremiumrisk

Default

premiumrisk

rate Exchange

E

Eii

e

Risk Premia in Advanced and Emerging Markets

The first part of the interest rate spread is the currency premium:

The second part of the interest rate spread is known as the country premium:

premiumrisk

rate ExchangepremiumCurrency

peso/$

peso/$

E

E e

Country premium Default

risk premium

FIGURE 9-6 (1 of 2)

Interest Rate Spreads: Currency Premiums and Country Premiums When advanced countries peg, the interest rate spread is usually close to zero, and we can assume i = i*. An example is Denmark’s peg to the euro in panel (a), where the correlation between the krone and euro interest rates is 0.99.

Risk Premia in Advanced and Emerging Markets

Interest Rate Spreads: Currency Premiums and Country Premiums (continued)

When emerging markets peg, interest rate spreads can be large and volatile. An example is Argentina’s peg to the U.S. dollar, where the correlation between the peso interest rate and the U.S. interest rate is only 0.38.

Risk Premia in Advanced and Emerging Markets