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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.

    Preliminaries and Assumptions

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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.

    Preliminaries and Assumptions

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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 centra