1 / 35

Anatomy of a Currency Crisis

Anatomy of a Currency Crisis. What Constitutes a “Crisis” ?. Large, rapid depreciation of a currency price Sudden, dramatic, reversal in private capital flows. The “Crisis” period is typically followed by a recession. Note: The names and dates have been changed to protect the innocent!.

alana-cervantes
Download Presentation

Anatomy of a Currency Crisis

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Anatomy of a Currency Crisis

  2. What Constitutes a “Crisis” ? • Large, rapid depreciation of a currency price • Sudden, dramatic, reversal in private capital flows The “Crisis” period is typically followed by a recession. Note: The names and dates have been changed to protect the innocent!

  3. Exchange Rate (per $US) Crisis Date

  4. Foreign Investment (Millions of $s)

  5. Currency Pegs Imagine yourself driving down a straight stretch of road. If the alignment on your car is good, you can let go of the steering wheel and the car stays on the road……

  6. Currency Pegs However, if your alignment is not perfect, you need to act to stay on the road. Otherwise…

  7. Currency Pegs On the other hand, your alignment could be perfect, but if the road has an unexpected curve….

  8. Currency Pegs A peg above the equilibrium will involve buying your currency (loss of reserves) F/$ Supply e A peg at the equilibrium price can be maintained forever! e A peg below the equilibrium price will involve selling your currency (increase in reserves) e Demand $

  9. Remember, a country only has a finite supply of foreign reserves….once their gone, the game is over! LiabilitiesAssets $ 10,000,000 (Currency) E 2,000,000 (Euro) E 3,000,000 (ECB Bonds) E 5,000,000 X 1.30 $/E $ 6,500,000 $ 3,500,000 (T-Bills) $10,000,000 reserve ratio = 59%

  10. Bad Policies… Initially , a country is pegging at or near the equilibrium value of its currency F/$ Supply e Demand $

  11. Bad Policies… An incompatible policy could pull the equilibrium away from the pegged level – this forces a loss in reserves! F/$ Supply Supply’ e e Demand $

  12. …or Bad Luck! Initially , a country is pegging at or near the equilibrium value of its currency F/$ Supply e Demand $

  13. or Bad Luck! F/$ Supply Suddenly, demand drops – this lowers the equilibrium exchange rate and forces the central banks to act (buying back currency and losing reserves) e e Demand Demand’ $

  14. What causes these sudden reversals? • Persistent inflation • High Money Growth • Low Economic Growth • Large Deficits • Public • Private • Political Events • Natural Disasters • Market Sentiment Bad Policy Just the facts ma’am. Bad Luck

  15. Inflation Rates (Annualized) US Average Inflation

  16. Economic Growth Rates (Annualized)

  17. M2 Growth (Annualized) Average = 14% Average = 4%

  18. Government Deficit (Millions)

  19. Trade Deficit (Millions)

  20. Interest Rate (Overnight Rates)

  21. Official Reserve Assets (Millions of $) Central Bank Defense of Currency

  22. Long Run Fundamentals • Recall, the monetary framework with flexible prices (long run) resulted in the following (1+i) M Y* e = M* Y (1+i*) Relative Money Stocks Relative Interest Rates Relative Output

  23. Long Run Fundamentals High money growth and low economic growth generate inflation (Domestic Money Market) Domestic inflation generates expectations of a currency depreciation (PPP) High inflation raises nominal interest rates. This further lowers money demand (which creates even more inflation

  24. Short Run Deficits Trade Deficits create excess supply of currency. This creates expectations of a depreciation Large government deficits create the fear that the government might “monetize” the debt (Pay it off by printing money) Both deficits raise domestic interest rates. This makes domestic investment more expensive. As domestic investment slows down, so does economic growth

  25. How big is “too big”? • When does a trade deficit become unsustainable? • PV(Lifetime CA) = 0 (all debts must be repaid) • We need to examine the country’s ability to run trade surpluses in the future (i.e. repay its debts!) • Generally speaking, a trade deficit greater than 5% of a country’s GDP is considered “too big”

  26. Productivity Productivity measures the ability of a country to transform inputs into output Revenues Labor Capital (Shareholders) Creditors (bondholders) With high productivity, producers can raise revenues without having to raise prices (high growth with low inflation!)

  27. Labor Productivity Real GDP Real Output Y Total Hours Labor Productivity = = N Per Man-hour Real GDP (2004) $8,317 = $34/hr $10,397 $8,317 244.3 Subtract out Farm Output Divide by total hrs (Employment * Average Hrs * 52) Suppose that Output/hr in 1992 was equal to $28.hr, then Prod(1992) = 100 Prod(2003) = 100*(34/28) = 121.4

  28. Multifactor Productivity Labor productivity doesn’t correct for changes in the capital stock!! Real GDP Capital Y = A KβN 1-β(Production function) β = 1/3 Labor MFP Capital Growth Growth Rate of MFP = y – βk – (1-β)n Labor Growth Real GDP Growth

  29. Step 1: Estimate capital/labor share of income K = 30% N = 70% Step 2: Estimate capital, labor, and output growth %Y = 5% %K = 3% %N = 1% %A = 5 – (.3)*(3) + (.7)*(1) = 3.4% Multifactor Productivity

  30. Productivity Growth in the US

  31. Expectations & Multiple Equilibria • Suppose a country is under a fixed regime with the understanding that they will switch to a float under “extreme” circumstances • Further, assume that the country is currently in a strong economic position

  32. Case #1 Investors anticipate a devaluation Investors require a “risk premium” to compensate them for expected currency losses Higher interest rates choke off domestic investment The economy slips into a recession and devalues Case #2 Investors expect the peg to be maintained Interest rates remain low Domestic investment continues and the economy grows. No devaluation is required Expectations & Multiple Equilibria

  33. Multiple Equilibria • In the previous example, there exist two possible equilibrium (one with a devaluation, and one without). The economy can then switch between the two. This switching is driven entirely by expectations.

  34. Contagion • Contagion refers to the transmission of a currency crisis throughout a region • The Thai Baht in 1997 was followed shortly by crises in Malaysia, Indonesia, Korea • The Mexican Peso crisis in 1994 spread to Central and South America (“The Tequila Effect”) • The Russian collapse (2000) was followed immediately by Brazil

  35. Reasons For Contagion • Common Shocks • Trade Linkages • Common Creditors • Financial Interdependencies • Informational Problems and “Herding” behavior

More Related