Ch3 - Generations of Currency Crises Models

Chapter 3

Genera'ons of currency crises

models

Introduc'on

•  A currency crisis is a specula've a7ack on the foreign exchange value of a currency, resul'ng in a sharp deprecia'on or forcing the authori'es to sell foreign exchange reserves and raise domes'c interest rates to defend the currency.

Introduc'on

•  Currency crises have been the subject of an extensive economic literature, both theore'cal and empirical. Theore'cal models of currency crises are oBen categorized as first-‐, second-‐, or third-‐genera'on, though many models combine elements of more than one generic form.

Introduc'on

•  Gold standard: liberalised capital flows; •  Great Depression => Bre7on Woods: fixed exchange rates + restric'ons on capital flows;

•  1970s: collapse of B-‐Ws (1st genera'on models); Followed by gradual change and liberaliza'on;

•  1980s: debt crisis in La'n America; •  1992-‐93 EMS crisis (2nd genera'on); •  1997-‐98: Asian, Russian, La'n American crises (3rd genera'on).

First Genera'on Models

•  The first genera'on model developed by Krungman (1979).

•  1980s: debt crisis in La'n America •  The first genera'on models focus on inconsistencies between domes'c macroeconomic policies, such as an exchange rate commitment and a persistent government budget deficit that eventually must be mone'zed.

•  The deficit implies that the government must either deplete assets, such as foreign reserves, or borrow to finance the imbalance.


•  However, it is infeasible for the government to deplete reserves or borrow indefinitely.

•  Central Bank’s behavior


•  Therefore, without fiscal reforms, the government must eventually finance the deficit by crea'ng money.

•  Since excess money crea'on leads to infla'on, it is inconsistent with keeping the exchange rate fixed and first-‐genera'on models therefore predict that the regime inevitably must collapse.


•  The previous equa'on defines the condi'ons under which the fixed rate is viable and determines the level of foreign reserves compa'ble with a given fixed exchange rate.


•  Floa'ng exchange rate regime

•  Note that here we are assuming that central bank does not intervene in the foreign exchange market and so foreign reserves are constant at the ini'al level.

•  The value of the current exchange rate depends on its value one period ahead. The shadow exchange rate is the exchange rate that would prevail in the market if there were no interven'on in the foreign exchange market


•  An unsustainable peg •  Consider the situa'on in which the Central Bank expands the domes'c component of money supply at a constant rate indefnitely:

•  where is the rate of growth of domes'c credit


•  Under the fixed exchange rate regime: •  In order to defend the peg, the central bank will intervene in the foreign market by selling foreign reserves at the same rate of increase of the domes'c credit component of the money supply.

•  The monetary authority will eventually run out of foreign reserves and will be forced to abandon the peg.

•  This problem (e.g. of running out of reserves) becomes a crisis well before reserves smoothly go to zero.


•  Since we are in a framework in which everything is known in advance, traders in the foreign market will an'cipate the abandonment of the peg and at a certain point will start selling the domes'c currency so that reserves will be driven to zero abruptly. When do the speculators sell the currency?


•  Since domes'c credit is growing at a constant rate and since the shadow exchange rate depends on the path of money supply, we have that the shadow exchange rate will depreciate also at the constant rate

•  The a7ack on the domes'c currency will occur at 'me T at which the shadow exchange rate is equal to the fixed rate.


•  Any individual trader has the incen've to exchange domes'c currency for foreign currency before reserves run out. Suppose the a7ack occurs at 'me T1 >T then the exchange rate would jump from the fixed value and it would depreciate discretely. Traders that hold the currency will incur in a capital loss and since they know everything in advance they will sell the currency before T1.


•  Before the a7ack we had et+1 -‐ et = 0 and it = i*t •  ABer the a7ack the nominal exchange rate is given by the shadow exchange rate and it depreciates at the rate ; which implies that the domes'c interest rate is higher than the foreign one in order to preserve the UIP condi'on.

Second Genera'on Models

•  In second genera'on models of currency crises, best represented by Obsield (1986, 1994)

•  2nd genera'on : 1992-‐93 EMS crisis •  Policymakers weigh the cost and benefits of defending the currency and are willing to give up an exchange rate target if the costs of doing so exceed the benefits.


•  Costs and benefits of fixed exchange rate – Costs :

– Benefits :


•  In these models, doubts about whether the government is willing to maintain its exchange rate target can lead to the existence of mul'ple equilibrium, and a specula've currency a7ack can take place and succeed even though current policy is not inconsistent with the exchange rate commitment.


•  This is because the policies implemented to defend a par'cular exchange rate level, such as raising domes'c interest rates, may also raise the costs of defense by dampening economic ac'vity and/or raising bank funding costs.

•  The private sector understands the dilemma facing the government, and may ques'on the commitment to fixed exchange rate when other macroeconomic objec'ves are compromised.


•  In this framework, a specula've a7ack is more likely to succeed if higher interest rates exacerba'ng already weak domes'c employment or banking sector condi'ons.

•  Consequently, the 'ming of the a7ack -‐ and whether it will occur -‐ cannot be determined, as it is no longer unique.


•  These different explana'ons for currency crises are not mutually exclusive. The fundamental imbalances stressed by first-‐genera'on models make a country vulnerable to shiBs in investor sen'ment, but once a crisis does occur, the second-‐genera'on models help explain its self-‐reinforcing features.

Third Genera'on Models

•  Third-‐genera'on models are harder to characterize simply but generally focus on how distor'ons in financial markets and banking systems can lead to currency crises.

•  Different third genera'on models offer various mechanisms through which these distor'ons may lead to a currency crisis.

•  3rd genera'on: 1997-‐98 Asian, Russian, La'n American crises.


•  Some models stress how distor'ons may emerge in the form of credit constraints.

•  Aghion, Bacche7a, and Banerjee (2001) highlight that an ini'al deprecia'on of a currency raises the cost of foreign-‐currency debt obliga'ons of firms and lowers profits, which in turn may limit borrowing capacity when credit is constrained.

•  The subsequent fall in investment and output associated with these borrowing limita'ons may lower the demand for domes'c currency and trigger a currency crisis.


•  Other third-‐genera'on models highlight how financial liberaliza'on and government guarantees of private sector liabili'es can generate moral hazard and unsustainable fiscal deficits that can lead to crises.

•  McKinnon and Pill (1995): •  Financial liberaliza'on combined with deposit insurance may induce banks to fuel a lending boom involving both foreign and domes'c credit expansion that eventually leads to a banking and currency crisis.


•  Chang and Velasco (2002): •  The possibility of self-‐fulfilling interna'onal liquidity crises in an open economy with unrestricted capital markets in which banks issue deposits in domes'c and foreign assets, but have longer term illiquid investments that cannot be readily converted to cash in event of a bank run.


•  Dooley (2000) and Burnside, Eichenbaum, and Rebelo (2004) :

•  Implicit or explicit government guarantees to the banking system may give banks an incen've to take on foreign debt, making the banking system vulnerable to a7ack. The fragile banking sector in turn makes the task of defending the peg by hiking domes'c interest rates more difficult and may lead to the eventual collapse of the domes'c currency.

Ch3 - Generations of Currency Crises Models

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