L17_CCS - Balance of Payments Crises and Speculative...

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1 Lecture 17 Currency crisis Balance of Payments Crises and Speculative Attacks Speculative attacks: “Runs” on central bank as market participants rush to convert domestic currency into foreign currency; foreign currency reserves depleted; Balance of payment crisis (currency crisis) Currency is under selling pressure from speculative attack. If attack is “successful”, country is forced off of FX peg and currency devalues. Lecture 17 Currency crisis Recent Episodes of Currency Crisis The European Monetary System (1992-3): Belgium, Finland, Denmark, France, Ireland, Italy, UK, etc.; Africa FSA franc zone (1993-4): Benin, Congo, Central African Republic, etc. Mexico (1994-5): East Asia (1997-8): Indonesia, South Korea, Malaysia, Thailand, Philippine, etc. Russia (1998), Brazil (1999), Turkey (2001), Argentina (2001), etc.
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2 Lecture 17 Currency crisis One Example: EMS On a single day (July 30, 1993) the bank of France used F300 billion of its reserves in an attempt to keep the Franc within ERM limits. Between June to September in 1992, the Bank of England estimates that it used around $40 billion a month to defend the Sterling. Neither central bank succeeded. During the same period of 1992, Sweden spent $26 billion in six days trying to defend Krona, even raising interest rates to 500% overnight at one point, but no avail. Lecture 17 Currency crisis Why Are Currency Crises Important Associated with severe output loss: 56 countries study identifies 68 currency crises Average output loss is 5.9 percent of GDP Staggering 18.6 percent of GDP under twin crisis Frequency of currency crises has increased 1973 to present more than 1880-1973 Developed countries: 1 out of 10 Developing countries: 1 out of 4
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3 Lecture 17 Currency crisis Balance of Payments Crises and Speculative Attacks What causes exchange rate crises to occur? Can we predict when crises will occur? How are crises transmitted across countries? Are they “contagious”? Can crises be prevented? What is the IMF’s role in the management of crises? Lecture 17 Currency crisis Models of Currency Crisis First Generation Models: Inconsistency between domestic policies and exchange rate policy Second generation models: Self fulfilling expectations and multiple equilibrium Third generation models: Banks runs, financial crisis
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4 Lecture 17 Currency crisis First Generation Model Krugman (1979) and Flood and Garber (1984) Crisis are a result of government following policies that are inconsistent with a fixed exchange rate regime. Assumptions:
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This note was uploaded on 04/12/2008 for the course ECON 442 taught by Professor Chari during the Winter '08 term at University of Michigan.

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L17_CCS - Balance of Payments Crises and Speculative...

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