CRISIS: THE NEXT
GENERATION ?
By Paul KRUGMAN (2001)
A model for each context
Generation Crisis model
1° GCM Crisis of Bretton Woods (1971)
Krugman (‘79); Flood and Garber (‘84)
2°GCM European Monetary System crisis (1992)
Obstfeld (‘94)
3°GCM Asian crisis (1997-98)
Krugman (‘99)
4°GCM Internet Bubble (2001), Depression 2007
Krugman (’01)
1. First generation
Effort of CB to peg an exchange rate using
reserves
Irresponsible economic policy => Long-run
upward trend in shadow price
Shadow price > peg =>speculation attack=>
investors advance crisis
Irresponsible economic policy =>
Predectible and deterministic crisis
No => recession
2. Second generation
• No run out of reserve but policy choice
• Peg in uncomfortable level => strict monetary
policy => reduction of employment in the short
term
• If peg ceases to be credible => i increases =>
worsen employment + increase financial distress
=> selfulfilling crisis of confidence => more
speculative attacks
• Crisis are not the result of irresponsible policy
• Crisis can be sudden and no predictable
• Crisis is still harmless
3. Third generation
Simultaneous currency crisis and bank crisis
=> «twin crisis », three main variant models:
Moral hazard driven investement: Mc
Kinnon and Pill (199?)
Open-economy version of DiamondDybvig bank-run model: Chang and
Velasco(1998a,b)
Balances sheet implications of currency
depreciation
Third generation
Hypothesis:
 Small open economy
 One good
 Two périods
 a Mundell-Flemming framework with
(1) y = D(y, i) + NX(eP*/P, y)
(2) M/P = L(y, i)
(3) i = i*
A more realistic version of 3°GCM
To permit this simplest model to generate
crisis, Krugman adds a strong balance sheet
effect from currency depreciation
(1') y = D(y, i, eP*/P) + NX(eP*/P, y)
(2') M(e)/P = L(y, i)
Sudden large depreciation creates havoc on
balance sheet => crisis
« Original Sin »: key problem of 3rd
Generation Crisis models
• Why did local firms and banks borrowed in
foreign currency, hence facing an
enormous exchange rate risk (irrational).
• Foreign investors protect themselves of
currency crisis by lending in dollars in
emerging economies.
• Local firms and banks: Benefit: more
foreign capital. Cost: much larger
probability and costs of financial crisis.
Traditional answer to crisis
• IMF financial support: The “sterilized
intervenor of last resort”
• Rollovers and standstills: Alteration of the
composition of capital flight but not volume
• Monetary policy: To rule out self-fullfilling
crisis
• Fiscal policy: an expansive policy to jump
out of the bad equilibrium
• Structural reform: Increase confidence
Fourth generation (this paper)
4th generation model is a generalization of
the 3°GCM: not only the price of foreign
currency but all asset prices
• OPEN-ECONOMY
• CLOSED-ECONOMY
Fourth generation
The balance-sheet matter:
In an imperfect capital market the ability of firms to exploit
even profitable investment opportunities may depend on their
ability to provide sufficient collateral to let them borrow the
needed funds.
If the price of foreign exchange rises, and firms have foreign
currency debt
=> their net worth falls => reduction of their collaterals
Likewise a decline in confidence => declining asset prices =>
a fall in investment => validates both the decline in asset
prices and the fall in confidence.
HYPOTHESIS
• a small open economy, producing a single tradeable good
• N investors, each must borrow B of the good to get themeselves into
the business
• Each investors is also endowed with an equal share of a productive
resource ( the total quantity of that resource equal to K)
• 2 periods: in 0 investors can or cannot borrow “seed money”
necessary to get start; in 1 who has mad the initial investiment of B
can choose to produce according to a production function F(k)
• K = amount of resources used
• investors may use either more or less than he owns, selling any
surplus for a price q determinated ina competitive market
(buyers=borrower and seller=lender)
• n<N = potential investors actually went ahead.
• r = real interset rate (exogenous)
The case of perfect market…
(4) q = F’(K/n)
price is increasing in K
(5) EP = S(q)/(1+r) – B
profit
S(q) is the “surplus” earned in period 1 over and
above the cost.
S(q) will be decreasing in q;
so from (4) and (5) we see that the profitability of
investing is decreasing in the number of actual
investors.
If capital markets is perfect => there is a unique
equilibrium value n* between 0 and N
Discussion: equation (4)
Valuation of assets.
• (4) q = F’(K/n) Price is decreasing in K if decreasing
returns to scale.
• In intertemporal models: future marginal productivity net
of marginal costs, discounted, for marginal q(t).
• Discount rate: (1) economics: time preference + risk
premium.
• Discount rate: (2) finance: risk free return + risk
premium of an alternative asset, which belong to the
same class of risk of the asset to be valued
(opportunity cost and no opportunities of arbitrage).
Cash  Flowt 
Pr ice(t  0)  E 
t
(
1

i
)
t 1
T
Asset Price Equation
Valuation of Assets (cf. Efficient Market
Hypothesis) C(K): adjustment costs.
Cash  Flowt 
Pr ice (t  0)  E 
t
(1  i )
t 1
T
F ' ( K (t ))  C ' ( K (t ))
q(t  0)  E 
t
(1  i )
t 1
T
Profit Equation
(5) EP = S(q)/(1+r) – B
profit
Profit is discounted by (1+r) by Krugman.
Profits = pY-wL –q(t)(K(t)-(K(t-1)) – (1+r)(B(t).
Investment (new capital) is bought at the cost q(t).
S(q) will be decreasing in q.
See Kiyotaki and Moore flow of funds equation.
…and the case of imperfect market
• Problem of monitoring
• The lender’s only recourse in the case of non-payment is
the ability to seize the borrower’s marketable resource in
period 1. So the lender will not lend more than the
borrower’s collateral:
• (7) B < (qK/N)/(1+r)
• Suppose that (7) is always binding => that investing is
always profitable, if the seed money can be borrowed.
• But q is increasing in n => each investor will invest only if
enough other investors are also expected to invest =>
his collateral is worth enough to persuade lenders to give
him the necessary seed money.
Collateral constraint
(7) B < (qK/N)/(1+r)
For dynamical models: The debt repayment is
guaranted in expectation by the expected future
value of collateral.
(1+r(t)).B(t) < m.E(q(t+1)).K(t)/N
What matters is the expected price next period for
a collateral constraint, not the current one.
A transaction cost m matters. Not all durable
assets K(t) are “good” collateral.
Two Equilibria
One equilibrium is with all N potential investors investing =>
a high q => each investor can offer sufficient collateral to
raise the necessary seed money.
The other equilibrium is with no investment: In this hardedged model q=0 => nobody has collateral => nobody can
invest.
Self-fulfilling pessimism can cause investment to collapse,
not because of the exchange rate and transfer problems
stressed in the third-generation crisis models, but because
of the effects of confidence on domestic asset prices: FIRE
SALES and ILLIQUID ASSET MARKETS.
4°GCM IN A CLOSED ECONOMY
Predominance of domestic assets market rather
than currency
Some nominal stickiness, in which: ( q is tobin’s q)
=> Investments => output
(A1) y = y(q)
(A2) q = q(y,i)
higher
higher y => higher profits =>
(A3) i = MIN(i(y),0) monetary reaction function,
positive nominal rate constraint (liquidity trap).
Equation 1: Output and asset
prices
Y=C(q1,q2)+I(q1)+H(q2)+G(q)+(X-I)(q5).
H=housing investment, price q2.
I=Corporate investment, price q1.
H and I: Tobin’s q positive effect on
investment.
C: Wealth effect on consumption.
G: Fiscal policy endogenous reactions.
(X-I): Exchange rate q5 policies.
Non linear assumption Y(q)
May be:
• Low output: increases of asset prices have
little increasing effects on output.
• High output: increases of asset prices
have little increasing effects on output.
Discussion: equation (4)
Valuation of assets.
• Asset Price is increasing in expected cash flow, which
increases with future output Ey(t+1) (possibly autocorrelated with current output).
• Asset Price is decreasing with the discount rate,
which includes the monetary policy (risk-free) rate i. But
Monetary Policy Reaction function (Taylor Rule) imply
that the interest rate increases with expected output.
So Ambiguous effect of OUTPUT on ASSET PRICES.
• With liquidity trap, the second effect (increasing output
decreases asset price) disappears.
Cash  Flowt 
G( Ey(t  1))
q(t  0)  E 

t
1  MIN [i( Ey(t  1)),0]  Riskpremiu m
(1  i)
t 1
T
AA: Price decreases with output: discount
rate (monetary policy) effect dominates
AA: Price increase with output:
cash flow effect dominates,
compatible with liquidity trap.
AA: The cash flow effect first offset the
discount rate effect, then, for high output,
the monetary policy reaction dominates
Low equilibria: because increases of asset prices
have low effect on output: very large change of
output prices to shift to good equilibrium
3 or 2 equilibria
In the former diagram, a linear AA curve
leads to 2 equilibria in Krugman’s static
model.
Extensions to a dynamical system: 3
equilibria are often such that 1 and 3 are
stable and 2 unstable.
If low equilibrium 1 is stable: large external
shock to shift above equilibrium 2, in order
to converge to equilibrium 3.
Conclusion
Fourth GCM consider all assets prices,
considering that exchange rate is one asset
price among others (housing prices, equity
prices).
Fourth GCM stress the case of monetary
policy irrelevance in case of liquidity trap as
for Japan in the 1990’s.
The major role of housing asset price
Source : www.federalreserve.gov
date
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taux d'intérêt(%)
• The liquidity trap risk
Evolution des taux directeurs de la Fed
6
5
4
Taux à 3 mois
3
Taux à 6 mois
Taux à 1 mois
Taux à 1 an
2
1
0