Currency Crises

What is an Exchange Rate Crisis?

A big depreciation in the currency.
Typically 10%15% in advanced economies.

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What is an Exchange Rate Crisis?

A big depreciation in the currency.
Economist often set a higher bar for emerging markets
and developing countries (>20%).

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What is an Exchange Rate Crisis?

Two important observations from the data.
Exchange rate crises occur in advanced as well as in
emerging markets and developing countries.

Both political and economic costs.

Government reputation may be damaged.
Real economic costs and possibly (quite often) other
sorts of crises.

Advanced countries vs. developing countries

Following a crisis, advanced economies tend to recover
more quickly than emerging markets and developing
countries.

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How Costly Are Exchange Rate Crises?

Advanced countries vs. developing countries

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How Costly Are Exchange Rate Crises?

Exchange rate crises often associated with other types of
financial crisis
A banking crisis when banks and other financial institutions face
losses,insolvency and bankruptcy.
A default crisis when the governments unwillingness, or inability, to
honor principal/interest payments on its debt.

Relationship between the three types of crises.

Likelihood of a banking or default crisis increases when a country is
having an exchange rate crisis.
Likelihood of an exchange rate crisis increases when a country is
having a banking or default crisis.

Twin crises refer to two of the aforementioned crises

happening at once.
Triple crises refer to a combination of exchange rate,
banking, and default crises occurring at once.
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Summary
Exchange rate crises occur in both advanced
economies and developing countries.
There are significant costs, economic and
political, associated with these crises.
It is important to identify the sources of these
crises, so that countries can work toward
preventing them.

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Preliminaries and Assumptions

For simplicity
Home currency (peso) is pegged to U.S. dollar at 1:1.
Central bank controls money supply by buying and selling
two assets in exchange for cash.
Domestic bonds denominated in local currency (peso).
Foreign assets denominated in foreign currency (dollars).

Central bank holds reserves to intervene in the forex

market, and defend the peg.
Acts as a buyer or seller of last resort at 1 peso per US$.

For now, assume the peg is credible, so exchange rate

expected to remain unchanged.
From uncovered interest rate parity, i = i*

Output and income are exogenous, equal to Y.

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Preliminaries and Assumptions

Prices
Foreign price level is stable at P* = 1.
Short run: Home price level sticky at level P = 1.
Long run: if exchange rate peg holds, home price level
will be fixed at P = 1 (from PPP).

Money market
Real money demand: M/P = L(i)Y.
Real money demand = real money supply.
Monetary base M0 = M1 = M money supply.
No banking system

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The Central Bank Balance Sheet

The central bank balance sheet shows how a central
bank manages assets and liabilities.
Central bank may purchase two types of assets: domestic
credit (B) and reserves (R)
Domestic credit consists of domestic bonds (domestic assets).
If the central bank is a net buyer of bonds worth B, the money supply
changes by an amount M=B.

Reserves are foreign exchange reserves (foreign assets).

The central bank stands ready to exchange foreign currency at the
exchange rate peg of 1 peso per US$.
If the central bank is a net buyer of reserves worth R, the money
supply changes by an amount M=R.

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The Central Bank Balance Sheet

Suppose exchange pegged at 1 forever.
So all reserves were bought at 1:1 rate.

The central banks liabilities (M) are divided

between domestic credit (B) and reserves (R):

In changes:

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The Central Bank Balance Sheet

Central bank balance sheet condition:

Example:
Suppose the government purchases 500 million in domestic
bonds and 500 million in foreign assets (reserves).
Money supply is therefore equal to 1000 million pesos.

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Fixed, Floating, and the Role of Reserves

We assume further, for simplicity:
The central bank holds reserves in order to defend the
fixed exchange rate.
The exchange rate remains fixed if and only if the
central bank holds some reserves.
The exchange rate is floating if and only if the central
bank holds zero reserves.
In practice, central banks (and governments) may hold
reserves in fixed and floating exchange rate regimes for other
reasons, but this does not effect our logic.

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How Reserves Adjust to Maintain the Peg

Assume a fixed exchange rate regime.
Central bank sets domestic credit equal to B.
The level of reserves is R = M B.

What is R?
From money market equilibrium:

Based on assumptions, terms on the right-hand side of the

expression are exogenous and known.
i=i*, P fixed in short run, Y known, and B is chosen.
This implies a unique level of R and we see from the equation that
changes in money demand or domestic credit affect R.
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Graphical Analysis of
Central Bank Balance Sheet
Floating: R = 0 and M = B.
Floating line is a 45-degree line for the origin.

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Defending the Peg I:

Changes in Money Demand
A Shock to Home output (Y) or the Foreign
Interest Rate (i*).
Changes in home output or the foreign interest rate
affect money demand, and therefore affects the money
supply and reserves needed to defend the exchange
rate peg.
Assume the central bank leaves domestic credit
unchanged and the price level is fixed.
Therefore, a change in money demand leads to an
equal change in reserves.

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Defending the Peg I:

Changes in Money Demand
Why Does the Level of Money Demand
Fluctuate?
Happens in all countries, but emerging markets and
developing countries countries face more frequent and
larger money demand shocks.
Recall, output Y tends to be more volatile in emerging markets
and developing countries.
Also, if investors do not believe the peg is credible or think
there are other risks, then the domestic interest rate i need not
equal the foreign interest rate i*, creating an additional source
of money demand shocks via risk premiums.

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Defending the Peg I:

Changes in Money Demand
Example: M1 = 1000, B = 500 and R1 = 500.
A money demand shock leads to a 10% decrease in the
money supply: M2 = 900. Fixed line shifts.

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Defending the Peg I:

Changes in Money Demand
Example: M1 = 1000, B = 500 and R1 = 500.
Suppose a money demand shock (e.g., a fall in Y or
rise in i*) leads to a 10% decrease in the money supply:
M2 = 900.
How? To defend exchange rate peg (prevent
depreciation in the currency), central bank buys
domestic currency and sells foreign currency.
Reserves decrease: R2 = 400.
A 10% increase in money demand would have the
reverse effects (M3 = 1100 and R3 = 600).

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Defending the Peg I:

Changes in Money Demand
Example: M1 = 1000, B = 500 and R1 = 500.
A money demand shock leads to a 10% decrease in the
money supply: M2 = 900.

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Defending the Peg I:

Changes in Money Demand
The importance of the backing ratio.
Backing ratio = R/M
Percent of money supply held in reserves, 0 < R/M 1.
For a given level of B, and if R/M < 1, then all of the change in
M is absorbed by a change in R. The ratio R/M declines when
money demand decreases because the proportionate change
in reserves is larger than the in the money supply.

Backing ratio is an important indicator of central banks

ability to defend the exchange rate peg.
All else equal, a higher backing ratio means the central bank is
in a better position to defend the exchange rate peg (can
withstand larger shocks).

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Defending the Peg I:

Changes in Money Demand
Currency Board Operation.
Strictly speaking, a currency board requires that the
money supply is entirely backed by reserves, so M = R
and B = 0.
In our diagram, corresponds to the horizontal axis.
Backing ratio is always 100% or R/M = 1.
A currency board is known as a hard peg because for
a given money demand shock, a currency board
system is least likely to be forced off of the exchange
rate peg.

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Risk Premiums in Advanced and Emerging Markets

APPLICATION

According to uncovered interest parity (UIP)

condition, the foreign interest rate i* and
domestic interest rate i should be equal under a
fixed exchange rate regime.
In practice, however, several factors that create a
wedge, or interest rate spread, between the two.
The interest rate spread represents a risk premium
the compensation investors require above the
foreign interest rate to be willing to hold domestic
currency.

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Risk Premiums in Advanced and Emerging Markets

APPLICATION

Risk premium can be split into two pieces.

Currency premium: to compensate investors for
uncertainty about the exchange rate.

Country premium: to compensate investors for

uncertainty about property rights (access to assets,
like bank deposits in this case).

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Risk Premiums in Advanced and Emerging Markets

APPLICATION

Changes in risk premium test the peg, by causing money

demand shocks. Affect M = P L(i) Y, via interest rate i.
If the risk premium increases, then i increases, and this reduces
money demand (increasing the domestic interest rate), forcing
the central bank to sell reserves in order to defend the peg.
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Risk Premiums in Advanced and Emerging Markets

APPLICATION

Denmark and the euro (19992006)

Risk premium is the interest rate spread between the
interest rate in Denmark and the Eurozone.

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Risk Premiums in Advanced and Emerging Markets

APPLICATION

Argentina and the U.S. dollar (19912001)

Disaggregate Argentinas interest rate to reflect
country premium and currency premium.
Made possible by the existence of both peso and dollardenominated deposits in Argentina.
While an increase in default risk would increase interest rates
on both types of deposits, an increase in the currency
premium would only affect peso-denominated deposits.

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Risk Premiums in Advanced and Emerging Markets

APPLICATION

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Risk Premiums in Advanced and Emerging Markets

APPLICATION

Summary
DenmarkEurozone spread is much smaller and less
volatile than the ArgentinaU.S. spread.
Pegs in emerging markets and developing countries differ
from those in advanced countries.
These countries often suffer from policy credibility problems,
so a peg is more difficult to maintain.

Investors may revise their expectations based on

events outside of the country.
Evidence of contagion in global financial markets.
Argentinas interest rate increased in response to crises
abroad, often far away.

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