Understanding financial crises
Download
1 / 33

Understanding Financial Crises - PowerPoint PPT Presentation


  • 103 Views
  • Uploaded on

Understanding Financial Crises. Franklin Allen and Douglas Gale Clarendon Lectures in Finance June 9-11, 2003. Lecture 2. Currency Crises Franklin Allen University of Pennsylvania June 10, 2003 http://finance.wharton.upenn.edu/~allenf/. Introduction.

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about ' Understanding Financial Crises' - brianna-meyer


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.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
Understanding financial crises

Understanding Financial Crises

Franklin Allen and Douglas Gale

Clarendon Lectures in Finance

June 9-11, 2003


Lecture 2
Lecture 2

Currency Crises

Franklin Allen

University of Pennsylvania

June 10, 2003

http://finance.wharton.upenn.edu/~allenf/


Introduction
Introduction

Major theme of the banking crises literature

  • Central bank/government intervention is necessary to prevent crises

    From 1945-1971 banking crises were eliminated but currency crises were not


Many of the currency crises were due to inconsistent government macroeconomic policies

  • Explanations of currency crises are based on government mismanagement

  • Contrasts with banking literature where central banks/government are the solution not the problem


First generation models
First generation models government macroeconomic policies

  • Krugman (1979) and Flood and Garber (1984) show how a fixed exchange rate plus a government budget deficit leads to a currency crisis

  • Designed to explain currency crises like that in Mexico 1973-82



Ln P(t) attempts to peg the price of gold

Ln Pc

Ln P(0)

T

t


Ln P(t) attempts to peg the price of gold

Ln Pc

Ln P*

T

t

If the government pegs price at P*, what does the price path look like?

Can’t be an equilibrium because of arbitrage opportunity


Ln P(t) attempts to peg the price of gold

Ln Pc

Ln P*

T’

T

t

Equilibrium: Peg until T’ then there is a run on reserves and the peg is abandoned


Krugman (1979) realized that the model could be used to explain currency crises

  • Government is running a fiscal deficit

  • It can fix the exchange rate and temporarily fund the deficit from its foreign exchange reserves


Ln S(t) explain currency crises

Ln S*

T’

t

There is an exchange rate over time such that the “inflation tax” covers the deficit

Equilibrium has predictable run on reserves and abandonment of peg


Problems with first generation models
Problems with first generation models explain currency crises

  • Timing of currency crises is very unpredictable

  • There are often jumps in exchange rates

  • Government actions to eliminate deficits?

  • E.g. ERM crisis of 1992 when the pound and the lira dropped out of the mechanism


Second generation models
Second generation models explain currency crises

  • Obstfeld (1996): Extent government is prepared to fight the speculators is endogenous. This can lead to multiple equilibria.

  • There are three agents

  • A government that sells reserves to fix it currency’s exchange rate

  • Two private holders of domestic currency who can continue to hold it or who can sell it to the government for foreign currency


  • Each trader has reserves of 6 explain currency crises

  • Transactions costs of trading are 1

  • If the government runs out of reserves it is forced to devalue by 50 percent


High Reserve Game: Gov. Reserves = 20 explain currency crises

  • There is no devaluation because gov. doesn’t run out of reserves. If either trader sells they bear the transaction costs.

  • The unique equilibrium is (0, 0)


Low Reserve Game: Gov. Reserves = 6 explain currency crises

  • Either trader can force the government to run out of reserves

  • The unique equilibrium is (0.5, 0.5)


Medium Reserve Game: Gov. Reserves = 10 explain currency crises

  • Both traders need to sell for a devaluation to occur

  • Multiple equilibria (0.5, 0.5) and (1.5,1.5)


Equilibrium selection
Equilibrium selection explain currency crises

  • Sunspots – doesn’t really deal with issue

  • Morris and Shin (1998) approach

    • Arbitrarily small lack of common knowledge about fundamentals can lead to unique equilibrium


With common knowledge about fundamentals e.g. currency reserves C

Unique

Peg fails

CL

CU

Unique

Peg holds

Multiple


With lack of common knowledge reserves C

  • Major advance over sunspots

  • Empirical evidence?

Unique

Peg fails

C*

Unique

Peg holds


Twin crises
Twin Crises reserves C

  • Kaminsky and Reinhart (1999) have investigated joint occurrence of currency and banking crises

    • In the 1970’s when financial systems were highly regulated currency crises were not accompanied by banking crises

    • After the financial liberalizations that occurred in the 1980’s currency crises and banking crises have become intertwined


  • Important to develop theoretical models of twin crises


  • Panic based twin crises
    Panic-based twin crises followed by a currency crisis and this further exacerbates the banking crisis

    • Chang and Velasco (2000a, b) have a multiple equilibrium model like Diamond and Dybvig (1983)

    • Chang and Velasco introduce money as an argument in the utility function and a central bank controls the ratio of currency to consumption


    • Banking and currency crises are “sunspot phenomena” followed by a currency crisis and this further exacerbates the banking crisis

    • Different exchange rate regimes correspond to different rules for regulating the currency-consumption ratio

    • Policy aim is to reduce parameter space where “bad equilibrium” exists


    Fundamental based twin crises
    Fundamental-based twin crises followed by a currency crisis and this further exacerbates the banking crisis

    Allen and Gale (2000) extends Allen and Gale (1998) to allow for international lending and borrowing

    • Risk neutral international debt markets

    • Consider small country with risky domestic assets


    Banks
    Banks followed by a currency crisis and this further exacerbates the banking crisis

    • Use deposit contracts with investors subject to early/late liquidity shocks

    • Can borrow and lend using the international debt markets

    • Domestic versus dollar loans


    Domestic currency debt
    Domestic currency debt followed by a currency crisis and this further exacerbates the banking crisis

    Risk sharing achieved through:

    • Bank liabilities

      • Deposit contracts

      • Large amount of domestic currency bonds

    • Bank assets

      • Domestic risky assets

      • Large amount of foreign currency bonds


    • Government adjusts exchange rate so the value of banks’ foreign assets allows them to avoid banking crisis and costly liquidation

    • Risk neutral international (domestic currency) bond holders bear most of the risk while domestic depositors bear little risk

    • If portfolios large enough all risk transferred to international market



    Dollar denominated debt
    Dollar-denominated debt countries whose banks can borrow in domestic currency

    • The benefits that a central bank and international bond market can bring are reduced

      • Dollarization: The central bank may no longer be able to prevent financial crises and inefficient liquidation of assets

      • Dollar debts and domestic currency deposits: It may not be possible to share risk with the international bond market


    Policy implications
    Policy Implications countries whose banks can borrow in domestic currency

    • Is the IMF important as lender of last resort like a domestic central bank (Krugman (1998) and Fischer (1999)

      OR

    • It misallocates resources because it interferes with markets (Friedman (1998) and Schwartz (1998)?


    • Framework above allows these issues to be addressed countries whose banks can borrow in domestic currency

      • Case 1: Flexible Exchange rates and Foreign Debt in Domestic Currency – No IMF needed

      • Case 2: Foreign Borrowing Denominated in Foreign Currency – IMF needed to prevent banking crises with costly liquidation and contagion


    Conclusions
    Conclusions countries whose banks can borrow in domestic currency

    • When is government the problem and when is it the solution?

    • The importance of twin crises

    • Interaction of exchange rate policies and bank portfolios in avoiding crises and ensuring risk sharing