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Unformatted text preview: Fall Semester 09-10 Akila Weerapana Lecture 23: The Anatomy of a BOP Crisis I. OVERVIEW Now that we are done with the second midterm, the focus switches to your papers, which analyze international finance topics including studies of episodes of currency crises. So I thought I would conclude my lectures by giving a big picture lecture on the myriad features of a currency crisis. The goals here are four-fold, the first is to understand why some of the most significant balance of payments crises of the past occurred, second to understand how these crises spread, third to lay out the different ways in which countries responded to these currency crises, and finally, to see what lessons we can draw from these episodes to prevent crises from occurring in the future. Parallels can be drawn to an epidemic disease like H1N1, understanding why it occurs, how it spreads, how it can be treated and how it can be prevented. Some of you may be writing papers about individual countries affected by currency crises. I am not going to go into a great deal of detail on any one of these crisis episodes. My goal is not to make you an expert on any one of these episodes but someone who has a grasp of the key issues surrounding currency crises. II. THE ONSET OF A BOP CRISIS A Trade Shock A negative trade shock is a common cause of a BOP crisis because it worsens the countrys current account balance. The most relevant example now would be the fall in East Asian exports to the U.S and in E. European exports to the EMU following the recent recessions in the U.S. and in Europe. Another way in which trade shocks affects economies is through a sudden surge in imports. This is particularly true for countries that rely on imports of oil. Examples here include the impact of the oil price shocks of the 1970s on the the current account deficits of many developing countries. Too Many Budget Deficits Budget deficits, that are financed by borrowing from abroad, result in FA surpluses and CA deficits. The problem becomes particularly acute if the borrowing takes the form of f/x denominated loans. These loans will be hard to pay back as precisely the worst times - when the country is experiencing a BOP crisis due to insufficient reserves. A Foreign Interest Rate Shock As we have seen in this class, a rise in the foreign interest rate is particularly problematic for countries with fixed exchange rates because they lead to an outflow and an economic contraction. Examples include the German reunification of the early 1990s and the early 1980s period when Paul Volcker was tightening interest rates in the United States. Higher interest rates were driving the United States into recession and causing an appreciation of the dollar....
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