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!
Exchange Rate (per $US)
55
50
45
40
35
30
25
20
-17
-14
-11
-8
-5
-2
1
4
7
10
13
16
19
22
25
28
Crisis Date
Foreign Investment (Millions of $s)
3500
3000
2500
2000
1500 FDI
1000 Portfolio
500
0
-23
-19
-15
-11
1
5
9
13
17
21
-7
-3
-500
-1000
Currency Pegs
Imagine yourself driving
down a straight stretch of
road. If the alignment on
your car is good, you can let
go of the steering wheel and
the car stays on the
road……
Currency Pegs
However, if your alignment is not
perfect, you need to act to stay on
the road. Otherwise…
Currency Pegs
On the other hand, your
alignment could be perfect, but
if the road has an unexpected
curve….
Currency Pegs A peg above the equilibrium will
involve buying your currency (loss
of reserves)
F/$
Supply
e
A peg at the equilibrium price can
be maintained forever!
e
A peg below the equilibrium price
e will involve selling your currency
(increase in reserves)
Demand
$
Remember, a country only has a finite
supply of foreign reserves….once their
gone, the game is over!
Liabilities Assets
$ 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)
$10,000,000
reserve ratio = 59%
Bad Policies… Initially , a country is pegging at or
near the equilibrium value of its
currency
F/$
Supply
e
Demand
$
An incompatible policy could
Bad Policies… pull the equilibrium away
from the pegged level – this
forces a loss in reserves!
F/$
Supply Supply’
e
e
Demand
$
…or Bad Luck! Initially , a country is pegging at or
near the equilibrium value of its
currency
F/$
Supply
e
Demand
$
or Bad Luck!
F/$
Supply
Suddenly, demand drops – this
e lowers the equilibrium exchange
rate and forces the central banks
to act (buying back currency and
e losing reserves)
Demand
Demand’
$
What causes these
sudden reversals?
•Persistent inflation
•High Money Growth
•Low Economic Growth
Bad Policy
•Large Deficits
•Public
Just the facts
ma’am. •Private
•Political Events
Bad Luck •Natural Disasters
•Market Sentiment
Inflation Rates (Annualized)
12
10
US
8 Average
6 Inflation
4
2
0
-2
-4
-29 -24 -19 -14 -9 -4 1 6 11 16 21 26
Economic Growth Rates
(Annualized)
12
10
8
6
4
2
0
-2
-4
-6
-8
-4 -3 -2 -1 0 1 2 3 4 5 6 7
M2 Growth (Annualized)
Average = 14% Average = 4%
60
40
20
0
-20
-40
-60
Government Deficit (Millions)
40,000
30,000
20,000
10,000
0
-10,000
-20,000
-30,000
-40,000
-50,000
Trade Deficit (Millions)
6,000
5,000
4,000
3,000
2,000
1,000
0
-1,000
-2,000
-3,000
-4,000
Interest Rate (Overnight Rates)
30
25
20
15
10
5
0
Official Reserve Assets (Millions of $)
Central Bank Defense of Currency
1000 40,000
950 38,000
36,000
900
34,000
850 32,000
800 30,000
750 28,000
26,000
700
24,000
650 22,000
600 20,000
Gold Foreign Exchange
Long Run Fundamentals
Recall, the monetary framework with flexible prices
(long run) resulted in the following
M Y* (1+i)
e = M* Y (1+i*)
Relative
Money Stocks Relative
Relative Interest Rates
Output
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
Short Run Deficits
Trade Deficits create Large government deficits
excess supply of create the fear that the
currency. This creates government might “monetize”
expectations of a the debt (Pay it off by printing
depreciation money)
Both deficits raise domestic interest rates. This makes
domestic investment more expensive. As domestic
investment slows down, so does economic growth
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”
Productivity
Productivity measures the ability of a
country to transform inputs into output
Revenues
Labor Capital Creditors
(Shareholders) (bondholders)
With high productivity, producers can raise revenues without
having to raise prices (high growth with low inflation!)
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 Divide by total hrs
Farm Output (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
Multifactor Productivity
Labor productivity doesn’t
correct for changes in the
Real GDP Capital capital stock!!
Y = A KβN 1-β (Production function) β = 1/3
MFP Labor
Capital Growth
Growth Rate of MFP = y – βk – (1-β)n
Labor
Real GDP
Growth
Growth
Multifactor Productivity
Step 1: Estimate capital/labor
share of income
K = 30%
N = 70%
%A = 5 – (.3)*(3) + (.7)*(1)
Step 2: Estimate capital, labor,
and output growth = 3.4%
%Y = 5%
%K = 3%
%N = 1%
Productivity Growth in the US
3
2.5
2
1.5
1
0.5
0
1919- 1929- 1941- 1948- 1973- 1989- 1995-
1929 1941 1948 1973 1989 2000 2000
Labor Productivity MFP
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
Expectations &
Multiple Equilibria
Case #1 Case #2
Investors anticipate a Investors expect the
devaluation peg to be maintained
Investors require a “risk
Interest rates remain low
premium” to compensate
them for expected Domestic investment
currency losses continues and the
Higher interest rates economy grows. No
choke off domestic devaluation is required
investment
The economy slips into a
recession and devalues
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.
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
Reasons For Contagion
Common Shocks
Trade Linkages
Common Creditors
Financial Interdependencies
Informational Problems and “Herding”
behavior