Economics 315 International MacroeconomicsLecture 9: Currency Crises

Dr. Keyu Jin

London School of Economics

December 4, 2013

Balance of Payments Crises

•Many fixed exchange rate regimes have collapsed

•Britain and US forced off gold standard during First World War

•1946-71 IMF system of fixed but adjustable exchange rates

•Mexico and Argentina during 1970s and early 1980s

•european Monetary system in 1992, Mexico 1994

•Asian crisis of 1997

•What are the causes and the timing of currency crises?

•First generation models: macroeconomic mismanagement

as the primary cause

– To explain exchange rate crises in developing countries in the

1970s and 1980s

– These crises were preceded by unsustainably large

government fiscal deficits, financed by excessive domestic

credt creation that eventually exhausted central banks’ foreign

reserves

– Thus, the size of a country’s financial liabilities (fiscal deficit,

short-term debt, current account deficit) and/or sustained real

appreciation from domestic price-level inflation should signal

an increasing likelihood of a crisis.

•More recently, european Monetary System crisis of 1992 and

Asian crisis of 1997 did not have macroeconomic

mismanagement

•Crises independent of macro fundamentals

•Second generation models: self-fulfilling crises

– governments explicitly balances the costs of defending the

exchange rate against the benefits of realignment

– Multiple equilibria: costs of exchange rate defense depend on

the public’s expectations.

First Generation Currency Crises

•Government pursues fiscal policies incompatible with long-run

mainteance of the peg

– Government faces short-term domestic financing constraints that it

feels more important to satisfy than long-run maintenance of

external balance.

– Since it cannot borrow from any creditor, it turns to CB and hands

over bonds in exchange for cash to fund government deficit. CB’s

reserves must be decreasing in equal amounts.

•Speculators observe the decline of the central bank’s international

reserves and time a speculative attack in which they require the

remaining reserves in an instant

•Faced with a loss of all its foreign exchange reserves, the central

bank is forced to abandon the peg and to move to a free float.

•The speculative attack on the central bank during the final moments

of the peg is called a balance-of-payments, or foreign exchange,

crisis.

•First model attributed to Krugman (1986)

The model

•Money demand equation: (we eliminate y)

M

d

t

P

t

= ↵ � �i

t

where M

d

and P, i are levels of money, prices and the

nominal interest rate.

•Money supply follows from Central Bank balance sheet:

M

s

t

= FX

t

+ DC

t

•UIP condition that determines investor’s behavior

e

e

t+1

� e

t

e

t

= i

t

� i

⇤t

where e denotes level of exchange rate.

Assumptions:

(a) PPP where we normalize P

⇤to 1.

e

t

P

⇤t

P

t

= 1 with P

⇤t

= 1) e

t

= P

t

(b) We assume that there is perfect foresight and we

normalize the foreign interest rate to 0.

e

e

t+1

= e

t+1

with i

⇤t

= 0)e

e

t+1

� e

t

e

t

= i

t

(c) There is a lower bound on the level of foreign

reserves that the central bank owns.

FX

t

� 0

Solution of the model:

•Money market equilibrium

M

d

t

= M

s

t

) FX

t

+ DC

t

P

t

= ↵ � �i

t

•+ UIP

FX

t

+ DC

t

e

t

= ↵ � �0BBBB@e

e

t+1

� e

t

e

t

1CCCCA

•Fixed exchange Rate Regime:

e

t

= e 8t

•Which implies that the money demand is given by

M

d

t

= ↵e

•and the money market equilibrium,

FX

t

+ DC

t

e

= ↵ (1)

Sustainability of the regime

•If

FX

t

> ↵e � DC

t

the peg is unsustainable because at the given exchange rate e,

money supply is larger than money demand (a devaluation could

restore equilibrium by increasing money demand).

•example: Suppose that the sterling is pegged to the dollar at a given

rate e and the Bank of england ran out of dollar reserves. If at this

rate there is still demand for dollars, the only way the equilibrium

can be restored is if the dollar becomes more expensive, i.e. if there

is a devaluation of the exchange rate (e increases).

•Moreover, equation (1) implies that, in a fixed exchange rate regime,

changes in domestic credit have to be accompanied by changes in

reserve levels:

��FX

t

= �DC

t

•Let’s define the shadow exchange rate as the exchange rate

that would prevail in the market if there were no intervention in

the foreign exchange market. That is, the exchange rate that

would prevail if there was a floating exchange Rate Regime

(reserves are zero )

FX + DC

t

= ↵e

s

t

� �⇣e

s

t+1

� e

s

t

⌘(2)

where e

s

t

denotes the shadow exchange rate at t .

An unsustainable peg

•Consider the situation in which the Central Bank expands the

domestic component of money supply at a constant rate:

DC

t

= DC

t�1

+ µ

where µ is the change in domestic credit.

•Given that in a fixed exchange rate regime (see equation (1))

changes in domestic credit have to be accompanied by

changes in reserve levels, we have that:

��FX

t

= �DC

t

= µ

•In order to defend the peg, the central bank will intervene in

the foreign market by selling foreign reserves at the same rate

as the increase in the domestic credit component of the

money supply. The monetary authority will eventually run out

of foreign reserves and will be forced to abandon the peg.

The timing of the crisis:

•Since we are in a framework in which everything is known in

advance, traders in the foreign market will anticipate the

abandonment of the peg and at a certain point will start selling

the domestic currency so that reserves will be driven to zero

abruptly.

•Coming back to our example: The Bank of england is pegging

the pound to the dollar and we know that at some point the

peg will be abandoned and the pound will devalue against the

dollar. If speculators know that in advance, they will buy

dollars and sell pounds even before the central bank runs out

of reserves.

When do the speculators sell the currency?

•From the equation that gives the shadow exchange rate (eq.2),

taking differences over a period:

�DC

t

= ↵�e

s

t

� �⇣�e

s

t+1

��e

s

t

⌘(3)

and maintaining the assumption of constant growth rate µ in

domestic credit, and conjecting that �e

s

t

= �e

s

t+1

, we have:

�e

s

t

= µ/↵ (4)

•The shadow exchange rate depends on the path of money supply

and will depreciate also at a constant rate proportional to µ.

•The attack on the domestic currency will occur at time T at which

the shadow exchange rate is equal to the fixed rate.

Timing of attack

Attack must occur at T when e

s = e

•Argument:

– Suppose that the attack will occur at time T

2

< T then the

exchange rate will appreciate discretely but this cannot be an

equilibrium since people do not want to sell a currency that

will appreciate.

– Suppose the attack occurs at time T

1

> T then the exchange

rate would jump from the fixed value and it would depreciate

discretely. Traders that hold the currency will incur in a capital

loss and since they know everything in advance they will sell

the currency before T

1

.

•The attack occurs at time T .

Reserves will not deplete smoothly. Any individual trader has the

incentive to exchange domestic currency for foreign currency

before reserves run out.

Remember that events are perfectly anticipated. They know that

the exchange rate will depreciate when the peg breaks down, and

to avoid realizing losses on domestic currency assets, agents

attempt to convert the soon-overvalued domestic currency into

foreign currency before time of abandonment. This sudden rush

into long positions in the foreign currency will cause an immediate

exhaustion of available reserves.

Money market after the attack

•At the moment of the attack the money supply will fall (given

the loss in reserves).

•Money demand will contained by higher interest rates.

i

t

= i

⇤t

+ �e

t+1

= i

⇤t

+ µ/↵

That is, after the attack the nominal exchange rate is given by

the shadow exchange rate and it depreciates at a rate

proportional to µ, which implies that the domestic interest rate

is higher than the foreign one in order to preserve the UIP

condition.

Caveats of this model of currency crisis:

1 The root cause of the crisis is poor government policy. The

source of the upward trend in the shadow exchange rate is

given by the increase in domestic credit (the need for this

might arise for example because of fiscal deficits to be

financed by seigniorage)) solve fiscal problem and there is

no crisis. Speculative target is provided by government’s

pursuit of inconsistent policies: eg. persistent deficits together

with an exchange rate peg.

2 Model shows that speculative attacks can be rational

outcomes

3 Weaknesses:

– Crisis is perfectly predictable

– Private sector is perfectly rational whereas monetary and

fiscal authorities are not

– First generation currency crisis model seems to do no harm -

no effect on output

Is this a good model for describing ERM crisis in 1992 ?

•There was no evidence of irresponsible policies in any of the

country involved.

•All countries had enough foreign exchange reserves and gold to buy

back at least 80 to 90 percent of their monetary bases

•There was no obvious trend in long-run equilibrium exchange rate

(shadow rate was not depreciating)

•Lastly, if governments had resources to fight off speculative attack,

why didn’t they do it? Need a model in which defense of currency is

costly.

•Forgoing the fixed exchange rate regime may be a policy

choice (and might not be inevitable)

•example: British official chose not to pay the price for

defending the pound with higher interest rates, while French

officials made the opposite decisions.

Second generation currency crisis model

•This class of model is characterized by multiple equilibria: if

agents expect a crisis to happen it might be too costly to

maintain the peg, if agents are confident the crisis might be

avoided.

•Defending a currency peg can have costs and benefits:

•If the currency is pegged at an uncomfortable level

(overvalued), the government is forced to accept a lower level

employment in the short-run than it would otherwise have

wanted.

•This cost may be higher if the peg is not credible. In this case,

investors will demand higher interest rates in order to hold

assets denominated in the country’s currency. If the

government defends the peg by providing those higher interest

rates, it will worsen employment.

•The benefits from pegging the exchange rate may be:

maintaining a nominal anchor (ie, credible monetary policy),

political, or other economic goals.

•Suppose that, as long as the peg is credible, the cost of

abandoning the peg is higher than the benefits. But if the peg

is no longer credible, this cost outweighs the benefits. So

even a government that would be willing to pay the price of

sustaining the peg in absence of speculative attack, it might

be unwilling to stand up in such situation. Speculators who

believe that other speculators are about to attack are

themselves encouraged to do so. (self-fulfilling crises of

confidence).

Policy trade-offs

•Define the desired exchange rate e

⇤as the exchange rate that

the government would choose if it had not made a

commitment to the fixed rate.

•Assume that the exchange rate peg will be more costly to

defend when devaluation is expected.

•Assume that there is a cost that arises once the government

decides to abandon the fixed exchange rate regime.

•These 3 elements are embedded in the following loss function

for the government:

L = [ (e⇤ � e) + ⌘�e

e]2

loss from defending

+ I (�e)loss from abandoning

,

with , ⌘ > 0. And we assume that the loss from abandoning

is given by the following function

I (�e) =0 for �e = 0

Q for �e > 0

•Suppose now that we start from a situation in which the

exchange rate is pegged at e. Different equilibria depend on

expectations.

Case 1) The government is expected to resist the pressure to

devalue, that is �e

e = 0. The loss from defending is

given by

L

d

d

= [ (e⇤ � e)]2

loss from defending

When this is an equilibrium?

- when, conditional on market expectations, the

government finds optimal to defend, that is when

L

d

d

< Q

Case 2) The government is expected to abandon and to

depreciate the exchange rate at the desired level e

⇤,

that is �e

e = e

⇤ � e. The loss from defending is

given by

L

a

d

= [ (e⇤ � e) + ⌘ (e⇤ � e)]2

loss from defending

When this is an equilibrium?

- when, conditional on market expectations, the

government finds optimal to defend, that is when

L

a

d

< Q .

•equilibrium is a situation in which the government choice is

compatible with market expectations. There is a region in

which both market expectations are validated

L

d

d

< Q < L

a

d

In this region we have multiple equilibria.

•The implications of this model are that for a given shape of the

loss function, and for a given desired exchange rate e

⇤, itmight become impossible for a country to defend an exchange

rate regime since the outcome depends entirely on whether

the market expects the government to devalue of not. A

speculative attack is self-fulfilling: it succeeds simply because

it was expected to occur without any reference to

fundamentals.

Analysis of the model:

1 the smaller the gap between e

⇤and e the easier it is to

defend;

2 the higher is Q , the cost of abandoning the peg, the easier it

is to defend, all else equal.

3 results depend on the fact that the government locked in an

exchange rate peg which is not optimal (i.e. it does not

correspond to the desired one).

Difference with first generation models:

1 no irresponsible policy; (but still not full commitment to the

peg)

2 no predictability of the time of crisis.

3 if the country leaves the peg, there is no negative impact on

employment and output. The monetary policy constraint is

removed and the result is positive in terms of short-run

macroeconomics benefits (think about Britain after 1992 and

Brazil very recent experience).