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1 of 95Copyright 2011 Worth Publishers International Economics Feenstra/Taylor, 2/e

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Exchange Rate Crises: How PegsWork and How They Break

Prepared by:Fernando QuijanoDickinson State University

201 Facts about

Exchange Rate

Crises2 How Pegs Work: The

Mechanics of a FixedExchange Rate

3 How Pegs Break I:Inconsistent FiscalPolicies

4 How Pegs Break II:Contingent MonetaryPolicies

5 Conclusions

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The typical fixed exchange rate succeeds for a few years,only to break. A recent study found that the averageduration of any peg was about five years.

When the break occurs, there is often a large and suddendepreciation. Such a collapse is known as an exchange

rate crisis. Understanding the causes and consequences of

exchange rate crises is a major goal of internationalmacroeconomics because of the damage they do.

There is an important asymmetry in regime changes: theshift from floating to fixed is generally smooth andplanned, but the shift from fixed to floating is typicallyunplanned and catastrophic.

Introduction

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1 Facts about Exchange Rate Crises

A simple definition of an exchange rate crisis would be abig depreciation. But how big is big enough to qualify asa crisis? In practice, in an advanced country, a 10% to15% depreciation might be considered large. In emergingmarkets, the bar might be set higher, say, 20% to 25%.Examples of such crises are shown in Figure 20-1.

Exchange rate crises can occur in advanced countries aswell as in emerging markets and developing countries.

The magnitude of the crisis, as measured by thesubsequent depreciation of the currency, is often muchgreater in emerging markets and developing countries.

What Is an Exchange Rate Crisis?

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FIGURE 20-1

Currency Crashes Inrecent years,developed and

developingcountries haveexperiencedexchange ratecrises.Panel (a) showsdepreciations of sixEuropeancurrencies aftercrises in 1992.Panel (b) showsdepreciations ofseven emerging

market currenciesafter crises between1994 and 2002.

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How Costly Are Exchange Rate Crises?FIGURE 20-2 (1 of 2)

The Economic Costs of

Crises In Exchange ratecrises can impose largeeconomic costs on acountry.After a crisis, growthrates in emerging

markets and developingcountries are, onaverage, two to threepercentage points lowerthan normal, an effectthat persists for aboutthree years.

In advanced countries,a depreciation istypically expansionary,and growth is, onaverage, faster justafter the crisis than it

was just before.

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Causes: Other Economic Crises

Exchange rate crises usually go hand in hand with other

types of economically harmful financial crises, especiallyin emerging markets.

If banks and other financial institutions face adverseshocks, they may become insolvent, causing them toclose or declare bankruptcy: this is known as a bankingcrisis.

In the public sector, if the government faces adverseshocks, it may default and be unable or unwilling to paythe principal or interest on its debts: this is known as asovereign debt crisis or default crisis.

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International macroeconomists thus have three crisis typesto consider: exchange rate crises, banking crises, and

default crises. Evidence shows they are likely to occursimultaneously:

The likelihood of a banking or default crisis increasessignificantly when a country is having an exchange ratecrisis.

The likelihood of an exchange rate crisis increasessignificantly when a country is having a banking ordefault crisis.

These findings show how crises are likely to happen inpairs, known as twin crises, or all three at once, known astriple crises, magnifying the costs of any one type of crisis.

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2 How Pegs Work: The Mechanics of aFixed Exchange Rate

The home currency is called the peso. The currency towhich home pegs is the U.S. dollar, and we assume theauthorities have been maintaining a fixed exchange rate,with E fixed at E = 1 (one peso per U.S. dollar).

The countrys central bank controls the money supply Mby buying and selling assets in exchange for cash. Thecentral bank trades domestic bonds (denominated inpesos), and foreign assets (denominated in dollars).

The central bank stands ready to buy and sell foreignexchange reserves at the fixed exchange. If it has noreserves, it cannot do this and the exchange rate is freeto float: the peg is broken.

Preliminaries and Assumptions

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k For now, we assume that the peg is credible. Uncoveredinterest parity then implies that the home and foreigninterest rates are equal: i = i *.

Output or income is assumed to be exogenous anddenoted Y .

There is a stable foreign price level P * = 1 at all times. Inthe short run, the home countrys price is sticky and fixedat a level P = 1. In the long run, if the exchange rate is

kept fixed at 1, then the home price level will be fixed at 1as a result of purchasing power parity.


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k The home countrys demand for real money balancesM /P is determined by the level of output Y and thenominal interest rate i and takes the usual form, M /P =L(i )Y . The money market is in equilibrium.

There is no financial system and the only money iscurrency, also known as M0 or the monetary base. Themoney supply is denoted M . We consider only the effectsof the actions of a central bank.


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k The home central banks sole liability is the money in

circulation. Suppose the central bank has purchased a quantity B

pesos of domestic bonds. By, in effect, loaning money tothe domestic economy, the central banks purchases areusually referred to as domestic credit created by thecentral bank. These purchases generate part of themoney supply and are also called the banks domesticassets.

The part of the home money supply created as a resultof the central banks issuing of domestic credit isdenoted B.

The Central Bank Balance Sheet

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k Now suppose the central bank also uses money to

purchase a quantity R dollars of foreign exchangereserves, usually referred to as reserves.

Because the central bank holds only two types of assets,the last two expressions add up to the total moneysupply in the home economy:


M Money supply

BDomestic credit

RReserves

(20-1)

Expressed not in levels but in changes: M

Change inmoney supply

BChange in

domestic credit

RChange in

reserves

(20-2)

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The central bank balance sheet contains the central

banks assets, B + R, and the money supply, its liabilities.


We are assuming that the exchange rate is fixed if and onlyif the central bank holds reserves; and the exchange rate isfloating if and only if the central bank has no reserves.

Fixing, Floating, and the Role of Reserves

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How Reserves Adjust to Maintain the Peg

What level of reserves must the central bank have tomaintain the peg? If the central bank can maintain a levelof reserves above zero, we know the peg will hold. If not,the peg breaks. Solving for the level of reserves:

R = M B Since money supply equals money demand, given by

M/P = PL (i )Y , then:

creditDomesticdemandMoneyReserves)( BY i L P R (20-3)

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How Reserves Adjust to Maintain the Peg

If the central bank bought more reserves than required

by Equation 20-3, home money supply would expandand the home nominal interest rate would fall, the pesowould depreciate, and the peg would break.

To prevent this, the central bank would need to intervenein the forex market to offset its initial purchase ofreserves, to keep the supply of pesos constant, and tokeep the exchange rate steady.

Similarly, if the central bank sells reserves for pesos, itwould cause the peso to appreciate and would have toreverse course and buy back the reserves. The pegmeans that the central bank must keep the reserves atthe level specified in Equation (20-3).

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Graphical Analysis of the Central Bank Balance SheetFIGURE 20-4 (1 of 2)

The Central Bank Balance Sheet Diagram This figure presents a simplified view ofcentral bank operations.On the 45-degree line, reserves are at zero, and the money supply M equalsdomestic credit B . Variations in the money supply along this line would cause theexchange rate to float.There is a unique level of the money supply M 1 (here assumed to be 1,000) thatensures the exchange rate is at its chosen fixed value.

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Graphical Analysis of the Central Bank Balance SheetFIGURE 20-4 (2 of 2)

The Central Bank Balance Sheet Diagram (continued)To fix the money supply at this level, the central bank must choose a mix of assetson its balance sheet that corresponds to points on line XZ, points at which domesticcredit B is less than money supply M . At point Z, reserves would be at zero; at pointX, reserves would be 100% of the money supply.Any point in between on XZ is a feasible choice. At point 1, for example, domesticcredit is B 1 = 500, reserves are R 1 = 500, and B 1 + R 1 = M 1 = 1,000.

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Graphical Analysis of the Central Bank Balance Sheet

A fixed exchange rate that always operates with reservesequal to 100% of the money supply is known as acurrency board system.

To sum up: if the exchange rate is floating, the centralbank balance sheet must correspond to points on the 45-degree floating line; if the exchange rate is fixed, thecentral bank balance sheet must correspond to points onthe vertical fixed line.

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Defending the Peg I: Changes in the Level of Money Demand

We first look at shocks to money demand and how they affect reservesby altering the level of money supply M .

A Shock to Home Output or the Foreign Interest Rate Supposeoutput falls or the foreign interest rate rises. We treat either of theseevents as an exogenous shock, all else equalSuppose the endogenous shock decreases money demand by 10% atthe current interest rate.

A fall in the demand for money would lower the interest rate in themoney market and put depreciation pressure on the home currency. Tomaintain the peg, the central bank must keep the interest rateunchanged. To achieve this goal, it must sell 100 million pesos ($100million) of reserves, in exchange for cash, so that money supplycontracts as much as money demand.

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The central banks balance sheet will then be as follows:

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FIGURE 20-5 (1 of 3)

Shocks to Money Demand If money demand falls, interest rates tend to fall, leadingto pressure for an exchange rate to depreciate. To prevent this, the central bankmust intervene in the forex market and defend the peg by selling reserves. Thislowers the money supply. The banks objective is to keep the interest rate fixed andto ensure that money supply equals money demand.

As shown here, the money supply declines from M1 = 1,000 to M2 = 900.

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Shocks to Money Demand (continued)If domestic credit is unchanged at B1 = 500, the change in the central bank balancesheet is shown by a move from point 1 to point 2, and reserves absorb the moneydemand shock by falling from R1 = 500 to R2 = 400.

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Shocks to Money Demand (continued)An opposite positive shock is shown by the move from point 1 to point 3, where M3= 900 and R3 = 600.In a currency board system, a country maintaining 100% reserves will be on thehorizontal axis with zero domestic credit, B = 0. A currency board adjusts to moneydemand shocks by moving from point 1 to points 2 or 3.

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The Importance of the Backing Ratio The ratio R /M iscalled the backing ratio, and it indicates the fraction of themoney supply that is backed by reserves on the centralbank balance sheet.

In general, for a given size of a shock to money demand, a

higher backing ratio will better insulate an economyagainst running out of reserves, all else equal .

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Currency Board Operation A maximum backing ratio of100% is maintained at all times by a currency board.

In figure 20- 5, at points 2 or 3 reserves are equal tomoney supply and equal to money demand.

A currency board keeps reserves at a maximum 100%, sothe central bank can cope with any shock to moneydemand without running out of reserves.

Currency boards are considered a hard peg because their

high backing ratio ought to confer on them greaterresilience in the face of money demand shocks.

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Why Does the Level of Money Demand Fluctuate? Under our assumptions, money demand shocks originateeither in shocks to home output Y or the foreign interestrate i * (because under a credible peg i = i *).

Since output fluctuations are more volatile in emerging

markets and developing countries, the prudent level ofreserves is likely to be much higher in these countries.

If the peg is not fully credible and simple interest parityfails to hold, the home interest rate will no longer equal the

foreign interest rate, and additional disturbances to homemoney demand can be caused by the spread between thetwo.

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Defending the Peg II: Changes in the Composition ofMoney Supply

A Shock to Domestic Credit

Here we assume that domestic output and the foreigninterest rate are unchanged. The money supply is M1 =1,000 million pesos.

Then, the bank expands domestic credit from $500 millionpesos by buying B = $100 million of peso bonds.

With more money in circulation, the interest rate in themoney market decreases, putting depreciation pressure

on the exchange rate.To defend the peg, the central bank sells 100 million pesos($100 million) of reserves, in exchange for cash, so thatthe money supply and the interest rate remain unchanged.

f f

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The central banks balance sheet will then be as follows:

There is no change in monetary policy as measured byhome money supply (or interest rates) because the sale

and purchase actions by the central bank are perfectlyoffsetting. Accordingly, this type of central bank action isdescribed as sterilization or a sterilized intervention, or asterilized sale of reserves.

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Sterilization If domestic credit rises, money supply rises, all else equal, interestrates tend to fall, putting pressure on the exchange rate to depreciate. To preventthis depreciation, keep the peg, and stay on the fixed line, the central bank mustintervene and defend the peg by selling reserves to keep the money supply fixed. Asshown here, the money supply is M 1 = 1,000.

( f )

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Sterilization If domestic credit increases from B 1 = 500 to B 2 = 600, the balance sheetmoves from point 1 to point 2, and reserves fall from R 1 = 500 to R 2 = 400.An opposite shock is shown by the move from point 1 to point 3, where B 3 = 400 andR 3 = 600.If the country maintains 100% reserves, it has to stay at point 1: a currency board

cannot engage in sterilization.

Defending the Peg II: Changes in the Composition of

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We also see in Figure 20-8 that sterilization is impossible

in the case of a currency board because a currency boardrequires that domestic credit always be zero and thatreserves be 100% of the money supply at all times.

If the change in money demand is zero, then M = 0;hence, the change in domestic credit, B > 0, must beoffset by an equal and opposite change in reserves, R =B < 0 (see Equations (20-2) and (20-3).

Holding money demand constant, a change in domesticcredit leads to an equal and opposite change in reserves,which is called a sterilization.

Defending the Peg II: Changes in the Composition of

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Why Does the Composition of the Money Supply

Fluctuate? Economists distinguish between banks thatare illiquid and those that are insolvent. Insolvency and bailouts. A private bank is insolvent if

the value of its liabilities (e.g., customers deposits)exceeds the value of its assets (e.g., loans, othersecurities, and cash on hand).

Illiquidity and bank runs. A private bank may be solvent,but it can still be illiquid: it holds some cash, but itsloans cannot be sold (liquidated) quickly at a high priceand depositors can withdraw at any time.

Figure 20-9 shows how loans from the central bank toprivate commercial banks affect the central bank balancesheet for these two important cases.

FIGURE 20 9 (1 of 2)

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The Central Bank and the Financial SectorIn panel (a), a bailout occurs when the central bank prints money and buys domesticassets the bad assets of insolvent private banks. There is no change in demand forbase money (cash), so the expansion of domestic credit leads to a decrease of

reserves.


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The Central Bank and the Financial Sector (continued)In panel (b), private bank depositors want to shift from holding deposits to holdingcash. If the central bank acts as a lender of last resort and temporarily lends theneeded cash to illiquid private banks, both the demand and supply of base money

(cash) rise, so the level of reserves is unchanged.

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If depositors fear that banks are either insolvent or illiquid, abank run may occur, and if the problem spreads to otherbanks, the panic may lead to a flight from domestic deposits

to foreign bank deposits. The Old Lady dothprotest too much: InSeptember 2007 theBank of England assuredNorthern Rock

depositors that the bankwould not fail. The banksbalance sheet waswidely believed to behealthy (solvency), butthe bank had run short ofcash to fund mortgages(illiquidity). Despiteofficial assurances,depositors ran all thesame, preferring cash inhand to governmentpromises.

As depositors demand foreign currency, theydrain reserves and make it more likely thatdevaluation will happen. Devaluation leads toa higher-risk premium, worsening economicconditions and a flight from the currency.

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3 How Pegs Break I: Inconsistent Fiscal Policies

We begin with a first-generation crisis model ofinconsistent fiscal policies.

We assume that output is fixed, and we allow the price levelto change, according to purchasing power parity (PPP). Thegovernment runs a persistent deficit (DEF) and is unable toborrow from any creditor. It turns to the central bank forfinancing.

In this type of environment, economists speak of a situationof fiscal dominance in which the monetary authoritiesultimately have no independence.

The Basic Problem: Fiscal Dominance

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3 How Pegs Break I: Inconsistent Fiscal Policies

Domestic credit B increases by an amount B = DEF everyperiod and is growing at a constant positive rate, B/B = .

Every change in the level of domestic credit leads to anequal and opposite change in the level of reserves.Reserves must eventually run out. At that point, the pegbreaks and the central bank shifts from a fixed exchangerate regime to a floating regime, in which the money supplyequals domestic credit, M = B.

The crisis happens because authorities are willing to let ithappen because of overriding fiscal priorities.

The Basic Problem: Fiscal Dominance

The Myopic Case

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y pFIGURE 20-13 (1 of 3)

An Exchange Rate Crisisdue to InconsistentFiscal Policies: Myopic

CaseIn the fixed regime,money supply M is fixed,but expansion ofdomestic credit B implies that reserves Rare falling to zero.Suppose the switch tofloating occurs whenreserves run out at time4.Thereafter, the monetarymodel tells us that M , P ,and E will all grow at aconstant rate (here, 10%per period).

The Myopic Case

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Case (continued)The expected rates ofinflation anddepreciation are nowpositive, and the Fishereffect tells us that theinterest rate must jumpup at period 4 (by 10percentage points). Theinterest rate increasemeans that real moneydemand M /P = L (i )Y fallsinstantly at time 4.

The Myopic Case

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Case (continued)The money supply doesnot adjust immediately,so this jump in M /P mustbe accommodated by a

jump in prices P . Tomaintain purchasingpower parity, E must also

jump at the same time.Hence, myopic investorsface a capital loss onpesos at time 4.

The Forward-Looking Case

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FIGURE 20-14 (1 of 3)

An Exchange Rate Crisisdue to Inconsistent FiscalPolicies: Perfect-ForesightCaseIf investors anticipate acrisis, they will seek toavoid losses by convertingpesos to dollars beforeperiod 4.The rational moment to

attack is at time 2, thepoint at which the switchfrom fixed to floating isachieved without any

jumps in E or P .At time 2, the drop inmoney demand (due to the

rise in the interest rate)exactly equals the declinein the money supply (thereserve loss), and moneymarket equilibrium ismaintained without theprice level having to

change.

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The speculative attack model teaches an important lesson.One moment, a central bank may have a pile of reserves onhand, draining away fairly slowly, giving the illusion thatthere is no imminent danger. The next moment, the reservesare all gone.

The model can therefore explain why fixed exchange ratessometimes witness a sudden collapse rather than a long,lingering death.

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