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LEC14 Financial Crisis

LEC14 Financial Crisis - Macroeconomic Policy Class Notes...

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Macroeconomic Policy Class Notes Financial crises Revised: December 13, 2011 Latest version available at www.fperri.net/teaching/macropolicyf11.htm Financial crises have been a common occurrence throughout the 1990s. They are episodes in which a country which is pegging the exchange rate abandons the peg and this usually results in a sudden devaluation of the local currency. Although these crises have not been common throughout the 2000s the European debt crisis of 2011 has brought financial crises back to the center stage of economic policy discussion. To understand the causes and consequences of financial crises we need to understand what induced a country to peg in the first place. The advantages of fixed exchange rates In the previous class we established that under fixed exchange rates a country loses to a certain degree of its monetary independence (tie its hands). This can actually be a bad or a good thing. If the monetary authority is inflation prone then tying its hands might be an advantage. Below we show three examples of that. Figure 1 plots the differential of inflation rates between various European countries and Germany. All the European countries in the picture adopted some sort of fixed exchange rate policy with the German currency from 1978 on. We see that by fixing their exchange rate with the Germany many countries have been able to significantly reduce their inflation rates. This picture also explains why many European countries relinquished their monetary independence and joined the Euro. Figure 2 shows inflation rates of Argentina before 1991, when its exchange rate was floating, and after 1991, when the exchange rate was pegged to the dollar. We see that pegging the exchange rate has provided the Argentina monetary authority with discipline. Pictures like that are the main argument of advocates of dollarization. Figure 3 shows the effects of the moving peg (or target devaluation), implemented by Turkey with the aid of the IMF in January 2000, on the Turkish inflation rate.
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Financial Crises 2 Figure 1: 1 Figure 1: Inflation in Europe
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Financial Crises 3 0 100 200 300 400 500 1970 1975 1980 1985 1990 1995 2000 Fixed Exchange Rates Figure 2: Inflation in Argentina
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Financial Crises 4 0 40 80 120 160 200 2000:01 2000:07 2001:01 2001:07 IMF Program of target devaluation Depreciation Rate Inflation Rate Figure 3: Inflation in Turkey As you can see the constraint on the exchange rate (see the table in the previous lecture) also has forced a reduction in the money creation rate and a reduction of the inflation to an historical minimum. Notice though that after mid 2000, although the rate of depreciation kept declining, inflation rate has picked up again, signalling that money supply was still increasing. The money printing by the Turkey central bank eventually forced the abandonment of the target devaluation program, the Turkish lira has collapsed devaluing more than 30% in three days and inflation has climbed high again. This is not to say that the currency crisis has caused the high inflation.
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