Exchange Rate Crises
Roberto Chang
Rutgers University
Introduction
• Financial crises and currency crashes
have been a policy concern for a very long
time
• However, economic theories that may
explain them are relatively recent
• Key Material: chapter 9 of FT
What do Exchange Rate
Crises Look Like?
• “Crises” refer to sudden changes in some
variables (reserves, prices) and
abandonment of some policies
• While dramatic, crises episodes do not
seem to be completely chaotic
• The first economic model : Krugman 1979
“First Generation” Models
Basic Example (Flood-Garber)
• Small Open Economy
• Domestic Residents may hold domestic
currency, and domestic and foreign bonds
• Initially, the central bank pegs the
exchange rate at some value S
Assumptions on the Economy
• Money Demand Equation:
M(t)/P(t) = a0 – a1i(t)
• Purchasing Power Parity:
P(t) = P*(t)S(t) = S(t)
• Uncovered Interest Parity:
i(t) = i* + [∆S(t)/S(t)]
(∆S(t) = dS(t)/dt)
While the exchange rate is fixed at S,
i(t) = i* (by UIP)
and
M(t)/P(t) = M(t)/S(t)
= M(t)/S
= a0 – a1i*
 the nominal demand for money M(t) is
fixed at M(t) = S(a0 – a1i*)
Remark
• The implications that in a fixed exchange
rate the nominal demand for money is
M(t) = S(a0 – a1i*)
are discussed in FT
• For example, FT asks what happens if a0
falls, say.
Central Bank Behavior
• The central bank pegs the exchange rate
by standing ready to sell its reserves, R(t),
for domestic currency at the fixed rate S
• This policy is feasible only if reserves are
nonnegative. If reserves fall to zero, the
central bank must abandon the peg. Then
it is assumed that the currency floats.
The Central Bank Balance
Sheet
• CB balance sheet:
M(t) = R(t) + D(t)
where D(t): Central Bank credit to the rest of
the economy
• Observe that, if reserves are zero, M(t) =
D(t) (central bank always finances
government needs)
The Central Bank Balance
Sheet: Implications
FT emphasize some implications of the CB
balance sheet:
M(t) = R(t) + D(t)
1.For given M(t), an increase in CB credit
must result in a fall in reserves
2.FX Intervention and Sterilization
3.Why would D(t) change?
4.Currency Board Systems
Evolution of Government Credit
• Krugman and Flood-Garber assumed that
government credit must always increase
due to fiscal dominance: for all t,
∆D(t) = μ > 0
(Hence D(t) = D(0) + μt)
Key Problem
• Fixed exchange rate and central bank
credit policy are inconsistent. To see this,
recall
M(t) = R(t) + D(t)
• If the exchange rate is fixed, i = i*, so M(t)
= S(a0 – a1i*)
• D grows  then R must be falling. But
then R will be exhausted at some point
Exchange Rate Crises
• Krugman’s crucial insight: reserves will not
fall smoothly to zero, but they will be
exhausted in a final attack
• (Why? If reserves fell to zero smoothly,
then at the time of reserve exhaustion, call
it T, the exchange rate would depreciate
abruptly. But then everybody would
attempt to get rid of domestic currency
before T to avoid capital losses.)
Figure 9.12 Two Types of Exchange Rate Crisis
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.13 An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Myopic Case
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.13 (a) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Myopic Case
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.13 (b) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Myopic Case
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.13 (c) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Myopic Case
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.14 An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Perfect-Foresight Case
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.14 (a) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Perfect-Foresight Case
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.14 (b) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Perfect-Foresight Case
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.14 (c) An Exchange Rate Crisis due to Inconsistent Fiscal Policies: Perfect-Foresight Case
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.15 A Crisis in Peru: The Inconsistent Policies of the García Administration
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Noteworthy Aspects
• Reserves fall smoothly for a while, then
are exhausted in a final attack
• Crises are predictable: the time of the
attack and the fall in reserves are known in
advance
• Key driving force: inconsistent policy
Some Weaknesses
• Obstfeld 1994: in practice, some
governments seemed to be able to borrow
the reserves they need
• Abandonment of a fixed parity seems to
be a government decision (ERM 1992
crises)
• This led to “second generation” models
(driven by contingent policy)
Figure 9.16 (a) Contingent Commitments and the Cost of Maintaining a Peg
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.16 (b) Contingent Commitments and the Cost of Maintaining a Peg
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.16 (c) Contingent Commitments and the Cost of Maintaining a Peg
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Figure 9.17 Contingent Policies and Multiple Equilibria
Feenstra and Taylor: International Macroeconomics, Second Edition
Copyright © 2012 by Worth Publishers
Remark: Risk Premia in Advanced and Emerging Markets
Uncovered interest parity (UIP) requires that the domestic
return (the interest rate on home bank deposits) equal the
foreign interest rate plus the expected rate of depreciation
of the home currency.
When additional risks affect home bank deposits, a risk
premium is added to compensate investors for the
perceived risk of holding a home domestic currency deposit.
 E peso/$
e
i

Peso
interest
rate

*
i
Dollar
interest
rate

E peso/$



Default
 Exchange rate  




risk
premium
risk
premium

 

Expected rate of
depreciati on
of the peso
                
Interest rate spread
(equal to zero if peg is credible and there are no risk premiums)
Risk Premia in Advanced and Emerging Markets
The first part of the interest rate spread is the currency
premium:
 E peso/$
e
Currency
premium

E peso/$

 Exchange rate 


 risk premium 
The second part of the interest rate spread is known as the
country premium:
Country premium

 Default
 
risk premium



Risk Premia in Advanced and Emerging Markets
FIGURE 9-6 (1 of
2)
Interest Rate Spreads: Currency Premiums and Country Premiums When advanced
countries peg, the interest rate spread is usually close to zero, and we can assume i = i*.
An example is Denmark’s peg to the euro in panel (a), where the correlation between the
krone and euro interest rates is 0.99.
Risk Premia in Advanced and Emerging Markets
Interest Rate Spreads: Currency Premiums and Country Premiums (continued)
When emerging markets peg, interest rate spreads can be large and volatile. An example
is Argentina’s peg to the U.S. dollar, where the correlation between the peso interest rate
and the U.S. interest rate is only 0.38.