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Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate

The anatomy of balance-of-payments crisis Conclusion

A Model of Balance-of-Payments Crises


Paul Krugman

Journal of Money, Credit and Banking, 1979 Presented by Yeganeh Forouheshfar

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Outline
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Introduction The model Assumptions formulation Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis If investors didnt anticipate the end of pegging If investors correctly anticipate events Conclusion
Yeganeh Forouheshfar A Model of Balance-of-Payments Crises

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Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Introduction:
There are different ways to peg the exchange value:
Open market operation. Intervention in the forward exchange market. Direct operations in foreign assets.

Limits of pegging. Crisis in the balance of payment When the government is no longer able to defend a xed parity A standard crisis. Speculative attack (in the model).

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Assumptions formulation

A macroeconomic model:
The model was developed by Kouri (1976) Assumptions: Small country producing a single composite tradable good. The PPP holds : P = sP P is xed we can set P = 1 P=s We have fully exible prices and wages output is always at its full employment Y . Investors have choice between domestic and foreign money. Both currencies bare 0 nominal interest rate. Foreigners do not hold domestic money.
Yeganeh Forouheshfar A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Assumptions formulation

Balance of Payment: B = Y G C(Y T , W ) Total wealth of domestic residents: W = M +F P (2) (1)

The condition for portfolio equilibrium: Md M = = L()W P P (3)

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Assumptions formulation

The short run behaivior of the economy:

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Dynamic behavior with a exible exchange rate:


How can the exchange rate change? A change in M:
(Assumption) Money will be created only through decit and decit is entirely nanced by printing money: M =GT P Government adjusts its expenditure so that: (m = M/P, the money supply) G T = gm M MP P m= = (g )m P PP P The rate of change of real balance depends only on the rate of ination.
Yeganeh Forouheshfar A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Dynamic behavior with a exible exchange rate:


How can the exchange rate change?

A change in F : F = B = Y G C(Y T , W ) A change in


Sophisticated forward-looking behavior of the speculators (Assumption of perfect foresight) = P P ( m ) F

The dynamic system in the state variables: The dynamic system in the state variables = m = g (m/F ) m F = Y G C(Y T , m + F )
A Model of Balance-of-Payments Crises

Yeganeh Forouheshfar

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Dynamic behavior with a oating exchange rate

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Note : Real money supply depends positively on the stock of foreign money and is independent of the nominal stock of domestic money = The price level is proportional to the money supply and negatively related to F P = M.G(F )

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Dynamic behavior with a xed exchange rate


R : The stock of foreign money. Stabilize exchange rate Stabilize price level(P) Private savings : S = Y T C(Y T , W ) M Budget constraint = W = + F = S P But Private saving is a function of private wealth with S <0 W Investors believe that government continues to peg = 0 stable relationship between money holding and wealth.
Yeganeh Forouheshfar A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

With a change in wealth

L domestic money 1 L foreign money M = LS P

F = (1 L)S M M + R = G T = g( ) P P As long as money is pegged: R = (G T ) + LS Government budget constraint : R = LB (1 L)(G T )

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Dynamic behavior with a xed exchange rate:

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

If investors didnt anticipate the end of pegging If investors correctly anticipate events

The anatomy of balance-of-payments crisis:

The point when the balance-of-payment-crisis begins is when the speculators anticipate an abandonment of the xed exchange rate, it is always before the government would have run out of reserves in the absence of speculation! why?

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

If investors didnt anticipate the end of pegging If investors correctly anticipate events

The case that investors didnt anticipate the end of pegging:

As long as government has reserves left


M = L()W P =0

At the instant that reserves are exhausted Price level Demand for domestic money price level jumps.

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

If investors didnt anticipate the end of pegging If investors correctly anticipate events

Windfall capital loss in the absence of speculation:

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

If investors didnt anticipate the end of pegging If investors correctly anticipate events

If investors correctly anticipate events


Speculators attempt to get out of domestic money earlier:
Government: Liquidation of its reserves. Domestic resident: Altering the composition of portfolio.

Asset holdings before attack Asset holdings afterwards M F

M F

M M = P R P F =F +R
Yeganeh Forouheshfar A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

If investors didnt anticipate the end of pegging If investors correctly anticipate events

P = M G(F ) P M M = P G(F ) = ( P R)G(F + R) P No windfall capital loss 1= P =P


A threshold in the W,R space

L(0)W R G W L(0)W +R

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

If investors didnt anticipate the end of pegging If investors correctly anticipate events

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

If investors didnt anticipate the end of pegging If investors correctly anticipate events

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Introduction The model Dynamic behavior with a exible exchange rate Dynamic behavior with a xed exchange rate The anatomy of balance-of-payments crisis Conclusion

Conclusion:

The balance-of-payment crisis are a natural outcome of maximizing behavior by investors. Many kind of uncertainty could be introduced (R1 primary reserve, R2 secondary reserve) Limitations
Highly simplied macroeconomic model. The assumption that there are only 2 assets available is an unrealistic constraint on the possible action of the government.

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises

Appendix

For Further Reading

For Further Reading I

Paul Kurgman. A model of balance-of-payment crisis. Journal of Money, Credit and Banking , 11(3): 311325,1979. Kouri, Pentti J.K. The exchange rate and the balance of payments in the short run and in the long run: a monetary approach Scandinavian Journal of Economics , 78 :280304, 1978.

Yeganeh Forouheshfar

A Model of Balance-of-Payments Crises