1 of 122 2008 Worth Publishers International Economics ...

Slide 1:EXCHANGE RATE CRISES: HOW PEGS WORK AND HOW THEY BREAK

Slide 2:Chapter Outline Facts about Exchange Rate Crises What is an Exchange Rate Crisis? How Costly Are Exchange Rate Crises? How Pegs Work: The Mechanics of a Fixed Exchange Rate Preliminaries and Assumptions The Central Bank Balance Sheet Fixed, Floating, and the Role of Reserves How Reserves Adjust to Maintain the Peg

Slide 3:Chapter Outline How Pegs Work: The Mechanics of a Fixed Exchange Rate (continued) Graphical Analysis of the Central Bank Balance Sheet Defending the Peg I: Changes in the Level of Money Demand Defending the Peg II: Changes in the Composition of Money Supply The Central Bank Balance Sheet and the Financial System

Slide 4:Chapter Outline How Pegs Break I: Inconsistent Fiscal Policies The Basic Problem: Fiscal Dominance A Simple Model How Pegs Break II: Contingent Monetary Policies The Basic Problem: Contingent Commitment A Simple Model Conclusions Can We Prevent Crises? Two Types of Exchange Rate Crises

Slide 5:LEARNING OBJECTIVES 1. Facts about Exchange Rate Crises Define exchange rate crisis and identify these crises in the data. Identify the costs of exchange rate crises. Discuss how exchange rate crises relate to other crises.

Slide 6:What is an Exchange Rate Crisis? A �big� depreciation in the currency. Typically 10%�15% in advanced economies. Figure 9.1 (a): Currency Crashes In recent years, developed and developing countries have experienced exchange rate crises. Panel (a) shows depreciations of six European currencies after crises in 1992. Sources: Global Financial Data; econstats.com. Figure 9.1 (a): Currency Crashes In recent years, developed and developing countries have experienced exchange rate crises. Panel (a) shows depreciations of six European currencies after crises in 1992. Sources: Global Financial Data; econstats.com.

Slide 7:What is an Exchange Rate Crisis? A �big� depreciation in the currency. Economist often set a higher bar for emerging markets and developing countries (>20%). Figure 9.1 (b): Currency Crashes In recent years, developed and developing countries have experienced exchange rate crises. Panel (b) shows depreciations of seven emerging market currencies after crises between 1994 and 2002. Sources: Global Financial Data; econstats.com. Figure 9.1 (b): Currency Crashes In recent years, developed and developing countries have experienced exchange rate crises. Panel (b) shows depreciations of seven emerging market currencies after crises between 1994 and 2002. Sources: Global Financial Data; econstats.com.

Slide 8:What is an Exchange Rate Crisis? Two important observations from the data. Exchange rate crises occur in advanced as well as in emerging markets and developing countries. Both political and economic costs. Government reputation may be damaged. Real economic costs and possibly (quite often) other sorts of crises. Advanced countries vs. developing countries Following a crisis, advanced economies tend to recover more quickly than emerging markets and developing countries.

Slide 9:How Costly Are Exchange Rate Crises? Advanced countries vs. developing countries Figure 9.2: The Economic Costs of Crises Exchange rate crises can impose large economic costs on a country. After a crisis, growth rates in emerging markets and developing countries are on average 2 to 3 percentage points lower than normal, an effect that persists for about three years. In advanced countries, a depreciation is typically expansionary, and growth is on average faster just after the crisis than it was just before. Source: Maurice Obstfeld and Alan M. Taylor, 2004, Global Capital Markets: Integration, Crisis and Growth, New York: Cambridge University Press. Figure 9.2: The Economic Costs of Crises Exchange rate crises can impose large economic costs on a country. After a crisis, growth rates in emerging markets and developing countries are on average 2 to 3 percentage points lower than normal, an effect that persists for about three years. In advanced countries, a depreciation is typically expansionary, and growth is on average faster just after the crisis than it was just before. Source: Maurice Obstfeld and Alan M. Taylor, 2004, Global Capital Markets: Integration, Crisis and Growth, New York: Cambridge University Press.

Slide 10:How Costly Are Exchange Rate Crises? Exchange rate crises often associated with other types of financial crisis A banking crisis � when banks and other financial institutions face losses,insolvency and bankruptcy. A default crisis �when the government�s unwillingness, or inability, to honor principal/interest payments on its debt. Relationship between the three types of crises. Likelihood of a banking or default crisis increases when a country is having an exchange rate crisis. Likelihood of an exchange rate crisis increases when a country is having a banking or default crisis. Twin crises refer to two of the aforementioned crises happening at once. Triple crises refer to a combination of exchange rate, banking, and default crises occurring at once.

Slide 11:The Political Costs of Crises Exchange rate crises often associated with changes in government leadership. Why? Figure 9.3: The Political Costs of Crises Exchange rate crises usually impose large political costs on those in power. Compared with what is likely to happen during normal, noncrisis times, it is 22% more likely that one of the two main officials with economic responsibilities (the finance minister and the central bank governor) will be out of a job the year following a crisis. It is also 8% more likely that the head of government (such as a president, prime minister, or premier) will have to depart for one reason or another. Note: Data on heads of government are from 1971 to 2003, and data on finance ministers and central bank governors are from 1995 to 1999. Source: Jeffrey A. Frankel, 2005, �Mundell-Fleming Lecture: Contractionary Currency Crashes in Developing Countries,� IMF Staff Papers 52(2), 149�192. Figure 9.3: The Political Costs of Crises Exchange rate crises usually impose large political costs on those in power. Compared with what is likely to happen during normal, noncrisis times, it is 22% more likely that one of the two main officials with economic responsibilities (the finance minister and the central bank governor) will be out of a job the year following a crisis. It is also 8% more likely that the head of government (such as a president, prime minister, or premier) will have to depart for one reason or another. Note: Data on heads of government are from 1971 to 2003, and data on finance ministers and central bank governors are from 1995 to 1999. Source: Jeffrey A. Frankel, 2005, �Mundell-Fleming Lecture: Contractionary Currency Crashes in Developing Countries,� IMF Staff Papers 52(2), 149�192.

Slide 12:The Political Costs of Crises Exchange rate crises are economically costly, especially in developing countries and emerging markets.

Slide 13:The Political Costs of Crises In advanced economies, exchange rate crises affect public opinion, even if economy performs well.

Slide 14:Summary Exchange rate crises occur in both advanced economies and developing countries. There are significant costs, economic and political, associated with these crises. It is important to identify the sources of these crises, so that countries can work toward preventing them.

Slide 15:LEARNING OBJECTIVES2. How Pegs Work The central bank balance sheet shows the relationship between money supply, reserves, and domestic credit in fixed and floating exchange rate regimes. Conduct graphical analysis of fixed and floating regimes using a central bank balance sheet diagram. Define and discuss the importance of the backing ratio and sterilization. Analyze how the monetary authority defends an exchange rate peg in response to: Money demand shocks. Shocks to domestic credit. Understand how the existence of risk premiums affects a country�s ability to maintain the peg.

Slide 16:Preliminaries and Assumptions For simplicity� Home currency (peso) is pegged to U.S. dollar at 1:1. Central bank controls money supply by buying and selling two assets in exchange for cash. Domestic bonds denominated in local currency (peso). Foreign assets denominated in foreign currency (dollars). Central bank holds reserves to intervene in the forex market, and defend the peg. Acts as a buyer or seller of last resort at 1 peso per US$. For now, assume the peg is credible, so exchange rate expected to remain unchanged. From uncovered interest rate parity, i = i* Output and income are exogenous, equal to Y.

Slide 17:Preliminaries and Assumptions Prices Foreign price level is stable at P* = 1. Short run: Home price level sticky at level P = 1. Long run: if exchange rate peg holds, home price level will be fixed at P = 1 (from PPP). Money market Real money demand: M/P = L(i)Y. Real money demand = real money supply. Monetary base M0 = M1 = M money supply. No banking system

Slide 18:The Central Bank Balance Sheet The central bank balance sheet shows how a central bank manages assets and liabilities. Central bank may purchase two types of assets: domestic credit (B) and reserves (R) Domestic credit consists of domestic bonds (domestic assets). If the central bank is a net buyer of bonds worth B, the money supply changes by an amount M=B. Reserves are foreign exchange reserves (foreign assets). The central bank stands ready to exchange foreign currency at the exchange rate peg of 1 peso per US$. If the central bank is a net buyer of reserves worth R, the money supply changes by an amount M=R.

Slide 19:The Central Bank Balance Sheet Suppose exchange pegged at 1 forever. So all reserves were bought at 1:1 rate. The central bank�s liabilities (M) are divided between domestic credit (B) and reserves (R): In changes:

Slide 20:The Central Bank Balance Sheet Central bank balance sheet condition: Example: Suppose the government purchases 500 million in domestic bonds and 500 million in foreign assets (reserves). Money supply is therefore equal to 1000 million pesos.

Slide 21:Fixed, Floating, and the Role of Reserves We assume further, for simplicity: The central bank holds reserves in order to defend the fixed exchange rate. The exchange rate remains fixed if and only if the central bank holds some reserves. The exchange rate is floating if and only if the central bank holds zero reserves. In practice, central banks (and governments) may hold reserves in fixed and floating exchange rate regimes for other reasons, but this does not effect our logic.

Slide 22:How Reserves Adjust to Maintain the Peg Assume a fixed exchange rate regime. Central bank sets domestic credit equal to B. The level of reserves is R = M � B. What is R? From money market equilibrium: Based on assumptions, terms on the right-hand side of the expression are exogenous and known. i=i*, P fixed in short run, Y known, and B is chosen. This implies a unique level of R and we see from the equation that changes in money demand or domestic credit affect R.

Slide 23:Graphical Analysis of Central Bank Balance Sheet Floating: R = 0 and M = B. Floating line is a 45-degree line for the origin. Figure 9.4: The Central Bank Balance Sheet Diagram On the 45-degree line, reserves are at zero, and the money supply M equals domestic credit B. Variations in the money supply along this line would cause the exchange rate to float. There is a unique level of the money supply M1 (here assumed to be 1,000) that ensures that the exchange rate is at its chosen fixed value. To fix the money supply at this level, the central bank must choose a mix of assets on its balance sheet that corresponds to points on line XZ, points at which domestic credit B is less than money supply M. At point Z, reserves would be at zero; at point X, reserves would be 100% of the money supply. Any point in between on XZ is a feasible choice. At point 1, for example, domestic credit is B1 = 500, reserves are R1 = 500, and B1 + R1 = M1 = 1,000. Figure 9.4: The Central Bank Balance Sheet Diagram On the 45-degree line, reserves are at zero, and the money supply M equals domestic credit B. Variations in the money supply along this line would cause the exchange rate to float. There is a unique level of the money supply M1 (here assumed to be 1,000) that ensures that the exchange rate is at its chosen fixed value. To fix the money supply at this level, the central bank must choose a mix of assets on its balance sheet that corresponds to points on line XZ, points at which domestic credit B is less than money supply M. At point Z, reserves would be at zero; at point X, reserves would be 100% of the money supply. Any point in between on XZ is a feasible choice. At point 1, for example, domestic credit is B1 = 500, reserves are R1 = 500, and B1 + R1 = M1 = 1,000.

Slide 24:Graphical Analysis of Central Bank Balance Sheet Fixed regime: R > 0 and M > B. Fixed line is vertical at the given money supply. Currency board: M = R and B = 0. Figure 9.4: The Central Bank Balance Sheet Diagram On the 45-degree line, reserves are at zero, and the money supply M equals domestic credit B. Variations in the money supply along this line would cause the exchange rate to float. There is a unique level of the money supply M1 (here assumed to be 1,000) that ensures that the exchange rate is at its chosen fixed value. To fix the money supply at this level, the central bank must choose a mix of assets on its balance sheet that corresponds to points on line XZ, points at which domestic credit B is less than money supply M. At point Z, reserves would be at zero; at point X, reserves would be 100% of the money supply. Any point in between on XZ is a feasible choice. At point 1, for example, domestic credit is B1 = 500, reserves are R1 = 500, and B1 + R1 = M1 = 1,000. Figure 9.4: The Central Bank Balance Sheet Diagram On the 45-degree line, reserves are at zero, and the money supply M equals domestic credit B. Variations in the money supply along this line would cause the exchange rate to float. There is a unique level of the money supply M1 (here assumed to be 1,000) that ensures that the exchange rate is at its chosen fixed value. To fix the money supply at this level, the central bank must choose a mix of assets on its balance sheet that corresponds to points on line XZ, points at which domestic credit B is less than money supply M. At point Z, reserves would be at zero; at point X, reserves would be 100% of the money supply. Any point in between on XZ is a feasible choice. At point 1, for example, domestic credit is B1 = 500, reserves are R1 = 500, and B1 + R1 = M1 = 1,000.

Slide 25:Defending the Peg I: Changes in Money Demand A Shock to Home output (Y) or the Foreign Interest Rate (i*). Changes in home output or the foreign interest rate affect money demand, and therefore affects the money supply and reserves needed to defend the exchange rate peg. Assume the central bank leaves domestic credit unchanged and the price level is fixed. Therefore, a change in money demand leads to an equal change in reserves.

Slide 26:Defending the Peg I: Changes in Money Demand Example: M1 = 1000, B = 500 and R1 = 500. Suppose a money demand shock (e.g., a fall in Y or rise in i*) leads to a 10% decrease in the money supply: M2 = 900. How? To defend exchange rate peg (prevent depreciation in the currency), central bank buys domestic currency and sells foreign currency. Reserves decrease: R2 = 400. A 10% increase in money demand would have the reverse effects (M3 = 1100 and R3 = 600).

Slide 27:Defending the Peg I: Changes in Money Demand Example: M1 = 1000, B = 500 and R1 = 500. A money demand shock leads to a 10% decrease in the money supply: M2 = 900.

Slide 28:Defending the Peg I: Changes in Money Demand Example: M1 = 1000, B = 500 and R1 = 500. A money demand shock leads to a 10% decrease in the money supply: M2 = 900. Fixed line shifts. Figure 9.5: Shocks to Money Demand If money demand falls, interest rates tend to fall, leading to pressure for an exchange rate to depreciate. To prevent this, the central bank must intervene in the forex market and defend the peg by selling reserves and hence lowering the money supply to keep the interest rate fixed and ensure that money supply equals money demand. As shown here, the money supply declines from M1 = 1,000 to M2 = 900. If domestic credit is unchanged at B1 = 500, the change in the central bank balance sheet is shown by a move from point 1 to point 2, and reserves absorb the money demand shock by falling from R1 = 500 to R2 = 400. An opposite positive shock is shown by the move from point 1 to point 3, where M3 = 1,100 and R3 = 600. In a currency board system, a country maintaining 100% reserves will be on the horizontal axis with zero domestic credit, B = 0. A currency board adjusts to money demand shocks by moving from point 1' to point 2' or 3'. Figure 9.5: Shocks to Money Demand If money demand falls, interest rates tend to fall, leading to pressure for an exchange rate to depreciate. To prevent this, the central bank must intervene in the forex market and defend the peg by selling reserves and hence lowering the money supply to keep the interest rate fixed and ensure that money supply equals money demand. As shown here, the money supply declines from M1 = 1,000 to M2 = 900. If domestic credit is unchanged at B1 = 500, the change in the central bank balance sheet is shown by a move from point 1 to point 2, and reserves absorb the money demand shock by falling from R1 = 500 to R2 = 400. An opposite positive shock is shown by the move from point 1 to point 3, where M3 = 1,100 and R3 = 600. In a currency board system, a country maintaining 100% reserves will be on the horizontal axis with zero domestic credit, B = 0. A currency board adjusts to money demand shocks by moving from point 1' to point 2' or 3'.

Slide 29:Defending the Peg I: Changes in Money Demand The importance of the backing ratio. Backing ratio = R/M Percent of money supply held in reserves, 0 < R/M = 1. For a given level of B, and if R/M < 1, then all of the change in M is absorbed by a change in R. The ratio R/M declines when money demand decreases because the proportionate change in reserves is larger than the in the money supply. Backing ratio is an important indicator of central bank�s ability to defend the exchange rate peg. All else equal, a higher backing ratio means the central bank is in a better position to defend the exchange rate peg (can withstand larger shocks).

Slide 30:Defending the Peg I: Changes in Money Demand Currency Board Operation. Strictly speaking, a currency board requires that the money supply is entirely backed by reserves, so M = R and B = 0. In our diagram, corresponds to the horizontal axis. Backing ratio is always 100% or R/M = 1. A currency board is known as a hard peg because for a given money demand shock, a currency board system is least likely to be forced off of the exchange rate peg.

Slide 31:Defending the Peg I: Changes in Money Demand Why Does the Level of Money Demand Fluctuate? Happens in all countries, but emerging markets and developing countries countries face more frequent and larger money demand shocks. Recall, output Y tends to be more volatile in emerging markets and developing countries. Also, if investors do not believe the peg is credible or think there are other risks, then the domestic interest rate i need not equal the foreign interest rate i*, creating an additional source of money demand shocks via risk premiums.

Slide 32:Risk Premiums in Advanced and Emerging Markets According to uncovered interest parity (UIP) condition, the foreign interest rate i* and domestic interest rate i should be equal under a fixed exchange rate regime. In practice, however, several factors that create a wedge, or interest rate spread, between the two. The interest rate spread represents a risk premium�the compensation investors require above the foreign interest rate to be willing to hold domestic currency.

Slide 33:Risk Premiums in Advanced and Emerging Markets Risk premium can be split into two pieces. Currency premium: to compensate investors for uncertainty about the exchange rate. Country premium: to compensate investors for uncertainty about property rights (access to assets, like bank deposits in this case).

Slide 34:Risk Premiums in Advanced and Emerging Markets Changes in risk premium test the peg, by causing money demand shocks. Affect M = P L(i) Y, via interest rate i. If the risk premium increases, then i increases, and this reduces money demand (increasing the domestic interest rate), forcing the central bank to sell reserves in order to defend the peg.

Slide 35:Risk Premiums in Advanced and Emerging Markets Denmark and the euro (1999�2006) Risk premium is the interest rate spread between the interest rate in Denmark and the Eurozone. Figure 9.6 (a): Interest Rate Spreads: Currency Premiums and Country Premiums When advanced countries peg, the interest rate spread is usually close to zero, and we can assume i = i*. An example is Denmark�s peg to the euro in panel (a), where the correlation between the krone and euro interest rates is 0.99. When emerging markets peg, interest rate spreads can be large and volatile, due to both currency and country premiums. Note: Three-month interest rates for krone-euro; two-month for peso-dollar. Source: econstats.com. Figure 9.6 (a): Interest Rate Spreads: Currency Premiums and Country Premiums When advanced countries peg, the interest rate spread is usually close to zero, and we can assume i = i*. An example is Denmark�s peg to the euro in panel (a), where the correlation between the krone and euro interest rates is 0.99. When emerging markets peg, interest rate spreads can be large and volatile, due to both currency and country premiums. Note: Three-month interest rates for krone-euro; two-month for peso-dollar. Source: econstats.com.

Slide 36:Risk Premiums in Advanced and Emerging Markets Argentina and the U.S. dollar (1991�2001) Disaggregate Argentina�s interest rate to reflect country premium and currency premium. Made possible by the existence of both peso and dollar-denominated deposits in Argentina. While an increase in default risk would increase interest rates on both types of deposits, an increase in the currency premium would only affect peso-denominated deposits.

Slide 37:Risk Premiums in Advanced and Emerging Markets Figure 9.6 (b): Interest Rate Spreads: Currency Premiums and Country Premiums When advanced countries peg, the interest rate spread is usually close to zero, and we can assume i = i*. An example is Argentina�s peg to the U.S. dollar in panel (b), where the correlation between the peso interest rate and the U.S. interest rate is only 0.38. Note: Three-month interest rates for krone-euro; two-month for peso-dollar. Figure 9.6 (b): Interest Rate Spreads: Currency Premiums and Country Premiums When advanced countries peg, the interest rate spread is usually close to zero, and we can assume i = i*. An example is Argentina�s peg to the U.S. dollar in panel (b), where the correlation between the peso interest rate and the U.S. interest rate is only 0.38. Note: Three-month interest rates for krone-euro; two-month for peso-dollar.

Slide 38:Risk Premiums in Advanced and Emerging Markets Summary Denmark�Eurozone spread is much smaller and less volatile than the Argentina�U.S. spread. Pegs in emerging markets and developing countries differ from those in advanced countries. These countries often suffer from policy credibility problems, so a peg is more difficult to maintain. Investors may revise their expectations based on events outside of the country. Evidence of contagion in global financial markets. Argentina�s interest rate increased in response to crises abroad, often far away.

Slide 39:The Argentine Convertibility Plan before the Tequila Crisis The Convertibility Plan Argentina maintained a one-for one peg against the dollar, with Epeso/$ = 1. Tequila Crisis was an exchange rate and financial crisis in Mexico in December 1994. But it had consequences for Argentina. Here, we consider the beginning of the crisis�the aftermath is discussed in more detail in a later application. We can examine how the money supply and reserves fluctuated 1993�1997, and then plot these on the central bank balance sheet diagram.

Slide 40:The Argentine Convertibility Plan before the Tequila Crisis Figure 9.7 (a): Argentina�s Central Bank Operations, 1993�1997 In this period, one peso was worth one U.S. dollar. Panel (a) shows the money supply and reserves. The difference between the two is domestic credit. Six key dates are highlighted before, during, and after the Mexican Tequila crisis. Prior to the crisis, domestic credit was essentially unchanged, and reserves grew from $8 billion to $11 billion as money demand grew from M1 to M2 in line with rapid growth in incomes (move from point 1 to 2). After the crisis hit in December 1994, interest rate spreads widened, money demand fell from M2 to M3, but domestic credit stood still (to point 3) and $1 billion in reserves were lost. In 1995 there was a run on banks and on the currency, and the central bank sterilized by expanding domestic credit by 5 billion pesos and selling $5 billion of reserves as money demand remained constant (to point 4). Reserves reached a low level of $5 billion. By 1996 the crisis had passed and the central bank now replenished its reserves, reversing the earlier sterilization. Domestic credit fell by 5 billion pesos and reserves increased by $5 billion (to point 5, same as point 3). Further sterilized purchases of $4 billion of reserves brought the backing ratio up to 100% in 1997 (to point 6). Source: IMF, International Financial Statistics. Data compiled by Kurt Schuler. Figure 9.7 (a): Argentina�s Central Bank Operations, 1993�1997 In this period, one peso was worth one U.S. dollar. Panel (a) shows the money supply and reserves. The difference between the two is domestic credit. Six key dates are highlighted before, during, and after the Mexican Tequila crisis. Prior to the crisis, domestic credit was essentially unchanged, and reserves grew from $8 billion to $11 billion as money demand grew from M1 to M2 in line with rapid growth in incomes (move from point 1 to 2). After the crisis hit in December 1994, interest rate spreads widened, money demand fell from M2 to M3, but domestic credit stood still (to point 3) and $1 billion in reserves were lost. In 1995 there was a run on banks and on the currency, and the central bank sterilized by expanding domestic credit by 5 billion pesos and selling $5 billion of reserves as money demand remained constant (to point 4). Reserves reached a low level of $5 billion. By 1996 the crisis had passed and the central bank now replenished its reserves, reversing the earlier sterilization. Domestic credit fell by 5 billion pesos and reserves increased by $5 billion (to point 5, same as point 3). Further sterilized purchases of $4 billion of reserves brought the backing ratio up to 100% in 1997 (to point 6). Source: IMF, International Financial Statistics. Data compiled by Kurt Schuler.

Slide 41:The Argentine Convertibility Plan before the Tequila Crisis Central Bank Balance Sheet, 1993�1997 Figure 9.7 (b): Argentina�s Central Bank Operations, 1993�1997 In this period, one peso was worth one U.S. dollar. The difference between the two is domestic credit. Six key dates are highlighted before, during, and after the Mexican Tequila crisis. In panel (b), the balance sheet of the central bank at these key dates is shown. Prior to the crisis, domestic credit was essentially unchanged, and reserves grew from $8 billion to $11 billion as money demand grew from M1 to M2 in line with rapid growth in incomes (move from point 1 to 2). After the crisis hit in December 1994, interest rate spreads widened, money demand fell from M2 to M3, but domestic credit stood still (to point 3) and $1 billion in reserves were lost. In 1995 there was a run on banks and on the currency, and the central bank sterilized by expanding domestic credit by 5 billion pesos and selling $5 billion of reserves as money demand remained constant (to point 4). Reserves reached a low level of $5 billion. By 1996 the crisis had passed and the central bank now replenished its reserves, reversing the earlier sterilization. Domestic credit fell by 5 billion pesos and reserves increased by $5 billion (to point 5, same as point 3). Further sterilized purchases of $4 billion of reserves brought the backing ratio up to 100% in 1997 (to point 6). Source: IMF, International Financial Statistics. Data compiled by Kurt Schuler. Figure 9.7 (b): Argentina�s Central Bank Operations, 1993�1997 In this period, one peso was worth one U.S. dollar. The difference between the two is domestic credit. Six key dates are highlighted before, during, and after the Mexican Tequila crisis. In panel (b), the balance sheet of the central bank at these key dates is shown. Prior to the crisis, domestic credit was essentially unchanged, and reserves grew from $8 billion to $11 billion as money demand grew from M1 to M2 in line with rapid growth in incomes (move from point 1 to 2). After the crisis hit in December 1994, interest rate spreads widened, money demand fell from M2 to M3, but domestic credit stood still (to point 3) and $1 billion in reserves were lost. In 1995 there was a run on banks and on the currency, and the central bank sterilized by expanding domestic credit by 5 billion pesos and selling $5 billion of reserves as money demand remained constant (to point 4). Reserves reached a low level of $5 billion. By 1996 the crisis had passed and the central bank now replenished its reserves, reversing the earlier sterilization. Domestic credit fell by 5 billion pesos and reserves increased by $5 billion (to point 5, same as point 3). Further sterilized purchases of $4 billion of reserves brought the backing ratio up to 100% in 1997 (to point 6). Source: IMF, International Financial Statistics. Data compiled by Kurt Schuler.

Slide 42:The Argentine Convertibility Plan before the Tequila Crisis Money Demand Shocks, 1993-1994 April 1993, point 1. M = 12 bil. pesos, R = 8 bil. pesos, B = 4 bil. pesos. Backing ratio = 8/12 = 67%. November�December 1994, point 2. Money demand and supply increase, reserves grow. Backing ratio rises slightly to 11/15 = 73%. January�February 1995, point 3. Tequila crisis in Mexico leads to an increase in risk premium on Argentine deposits. Some flight from bank deposits to dollars. Reserves, money supply fall slightly, by 1 bil. Backing ratio remains relatively high at 10/14 = 71%.

Slide 43:The Argentine Convertibility Plan before the Tequila Crisis The increase in Argentina�s interest rate led to an economic recession with severe consequences for banks. The central bank provided assistance to the banking sector. Reserve drain very serious, could have exhausted reserves without help (IMF loan, and renewed private loans).

Slide 44:Defending the Peg II: Changes in the Composition of the Money Supply So far, central bank�s response to money demand shocks was assumed to be passive (domestic credit B remained unchanged.) Now, we consider changes to the composition of the money supply, holding the level of the money demand and supply fixed. The central bank employs sterilization to hold the money supply M fixed, by ensuring equal and opposite changes in B and R.

Slide 45:Defending the Peg II: Changes in the Composition of the Money Supply A Shock to Domestic Credit The central bank can buy/sell domestic bonds, affecting the composition of the money supply. Example: central bank buys 100 billion in domestic bonds. Sterilization implies that reserves decline by 100 billion to keep the money supply unchanged.

Slide 46:Defending the Peg II: Changes in the Composition of the Money Supply Point 2: Increase in B implies R decreases. Movement along the fixed line. (Point 3 is reverse). Figure 9.8: Sterilization If domestic credit rises, money supply rises, all else equal, interest rates tend to fall, putting pressure on the exchange rate to depreciate. To prevent this depreciation, keep the peg, and stay on the fixed line, the central bank must intervene and defend the peg by selling reserves to keep the money supply fixed. As shown here, the money supply is M1 = 1,000. If domestic credit increases from B1 = 500 to B2 = 600, the central bank balance sheet moves from point 1 to point 2, and reserves fall from R1 = 500 to R2 = 400. An opposite shock is shown by the move from point 1 to point 3, where B3 = 400 and R3 = 600. If the country maintains 100% reserves, it has to stay at point 1': a currency board cannot engage in sterilization. Figure 9.8: Sterilization If domestic credit rises, money supply rises, all else equal, interest rates tend to fall, putting pressure on the exchange rate to depreciate. To prevent this depreciation, keep the peg, and stay on the fixed line, the central bank must intervene and defend the peg by selling reserves to keep the money supply fixed. As shown here, the money supply is M1 = 1,000. If domestic credit increases from B1 = 500 to B2 = 600, the central bank balance sheet moves from point 1 to point 2, and reserves fall from R1 = 500 to R2 = 400. An opposite shock is shown by the move from point 1 to point 3, where B3 = 400 and R3 = 600. If the country maintains 100% reserves, it has to stay at point 1': a currency board cannot engage in sterilization.

Slide 47:Defending the Peg II: Changes in the Composition of the Money Supply Why does the composition of the money supply fluctuate? The central bank may buy or sell domestic credit for one of two reasons. To influence interest rates on different bonds. There is little evidence of this in practice. To lend in an emergency�to support the private financial system. (And build up such reserves before/after.) Extend credit to banks during a crisis to assist struggling banks in meeting their obligations to depositors (and/or other creditors, including other banks). Prevent spread of a banking crisis across the financial system and limit effects on real economic activity. To address either insolvency or illiquidity at banks.

Slide 48:Defending the Peg II: Changes in the Composition of the Money Supply To understand the workings and impact of central bank lending to private banks: We have to relax the assumption that the monetary base (M0) is equal to the money supply (M1 or M2). We have to understand the two types of banking problems and their solutions. Insolvency and bailouts. Illiquidity, bank runs and lender-of-last-resort.

Slide 49:Defending the Peg II: Changes in the Composition of the Money Supply Insolvency and bailouts. A private bank is insolvent when its liabilities exceed its assets. This occurs when banks suffer from losses in assets as a result of loan defaults. The government may prevent the bank�s failure through a bailout. The central bank offers cash to the bank. Since its loans have gone bad, and its balance sheet is �underwater,� the private bank can never pay back the central bank. Domestic credit increases and money supply remains unchanged, reducing reserves available for defending the peg.

Slide 50:Defending the Peg II: Changes in the Composition of the Money Supply Insolvency and bailouts. Figure 9.9 (a): The Central Bank and the Financial Sector In panel (a), a bailout occurs when the central bank prints money and buys domestic assets�the bad assets of insolvent private banks. There is no change in demand for base money (cash), so the expansion of domestic credit leads to a decrease of reserves. Figure 9.9 (a): The Central Bank and the Financial Sector In panel (a), a bailout occurs when the central bank prints money and buys domestic assets�the bad assets of insolvent private banks. There is no change in demand for base money (cash), so the expansion of domestic credit leads to a decrease of reserves.

Slide 51:Defending the Peg II: Changes in the Composition of the Money Supply Illiquidity and bank runs. A private bank may be solvent, but illiquid: has little cash, and most assets (loans) are illiquid. Bank run: If too many depositors try to withdraw cash at once, bank unable to honor payments. Bank run reflects increase in money demand (for cash). Lender of last resort: Central bank expands the money supply to meet increase in money demand. Domestic credit increases. Reserves unchanged.

Slide 52:Defending the Peg II: Changes in the Composition of the Money Supply Illiquidity and bank runs. Figure 9.9 The Central Bank and the Financial Sector In panel (a), a bailout occurs when the central bank prints money and buys domestic assets�the bad assets of insolvent private banks. There is no change in demand for base money (cash), so the expansion of domestic credit leads to a decrease of reserves. In panel (b), private bank depositors want to shift from holding deposits to holding cash. If the central bank acts as a lender of last resort and temporarily lends the needed cash to illiquid private banks, both the demand and supply of base money (cash) rise, so the level of reserves is unchanged.Figure 9.9 The Central Bank and the Financial Sector In panel (a), a bailout occurs when the central bank prints money and buys domestic assets�the bad assets of insolvent private banks. There is no change in demand for base money (cash), so the expansion of domestic credit leads to a decrease of reserves. In panel (b), private bank depositors want to shift from holding deposits to holding cash. If the central bank acts as a lender of last resort and temporarily lends the needed cash to illiquid private banks, both the demand and supply of base money (cash) rise, so the level of reserves is unchanged.

Slide 53:Defending the Peg II: Changes in the Composition of the Money Supply Reflections Insolvency and illiquidity hard to tell apart in reality. In �bad times� many assets values crash. (E.g. 2007-08). Should bank be saved? How to value its portfolio? At the old �normal� price or the prevailing �crash� price? Risk of systemic crisis hard to gauge. If people cannot tell good banks from bad banks, or if bad banks owe money to good banks. Liquidity provision will not endanger reserves if peso provision to banks offset by new peso demand by people. Err on the side of generous liquidity provision? Danger for a pegged regime. Liquidity provision can threaten reserves if there is a double drain from peso deposits to peso cash and then from peso cash to dollars.

Slide 54:The Argentine Convertibility Plan after the Tequila Crisis Argentina had experienced money demand shocks (1993�1994), but successfully defended the exchange rate peg. Banking Crisis,1995. The sharp increase in Argentina�s interest rate led to an economic contraction and a banking crisis. The recession led to loan defaults (insolvency) and eventually uncertainty, sparking bank runs (illiquidity).

Slide 55:The Argentine Convertibility Plan after the Tequila Crisis Banking Crisis,1995 January/February�May 1995 Central bank expanded domestic credit in response to insolvency and illiquidity. Net effect was little change in money demand/supply and a large reduction in reserves. Backing ratio fell sharply from 71% in February 1995 to 36% by May 1995 (cut in half). Argentina was running out of reserves rather quickly.

Slide 56:The Argentine Convertibility Plan after the Tequila Crisis Banking Crisis,1995 (Point 3 � Point 4)

Slide 57:The Argentine Convertibility Plan after the Tequila Crisis Banking Crisis,1995 (Point 3 � Point 4)

Slide 58:The Argentine Convertibility Plan after the Tequila Crisis Help from the IMF and Recovery Following Tequila crisis, IMF loans dollars to Argentina, increasing reserves, and a fund is established to bail out failing banks. May 1995�November 1996 (Point 4�Point 5) Banking crisis over, central bank replenishes reserves, reduces domestic credit, via sterilized intervention. Backing ratio returns to 71% by November 1996. November 1996�May 1997 (Point 5�Point 6) Central bank continues increasing reserves and decreasing domestic credit. Backing ratio continues to rise. 100% by May 1997.

Slide 59:The Argentine Convertibility Plan after the Tequila Crisis Postscript With 100% backing ratio, Argentina could have adopted a strict currency board system, strengthening its peg against the dollar, but did not formally do so. Scope for discretionary changes in domestic credit (sterilization) remained. The Convertibility Plan ended in 2001 with another banking system collapse (related to a fiscal/default crisis) that is discussed in more detail in Chapter 11.

Slide 60:The Central Bank Balance Sheet and the Financial System A More General Balance Sheet� A more realistic and detailed central bank balance sheet allows us to: Distinguish between different types of foreign and domestic assets, and also allow for liabilities. Track more complex central bank operations. Study the central bank�s relationship with the private financial system.

Slide 61:A More General Central Bank Balance Sheet Assets Foreign currency assets�to defend the peg Foreign currency reserves (in all FX currencies), and also in gold. Domestic assets�lending by central bank. Domestic government bonds purchased by central bank. Central bank lending to commercial/private banks. Liabilities Foreign currency liabilities. Foreign currency borrowing by central bank (FX debt issue). Domestic currency liabilities. Domestic currency borrowing by central bank (peso debt issue). Money supply, M. Currency in circulation�currency in the hands of the public. Reserve liabilities to commercial banks�currency in bank vaults, not in circulation.

Slide 62:A More General Central Bank Balance Sheet Summary items The main difference now is that foreign and domestic assets must be calculated net of liabilities. NFA = Net foreign assets = foreign assets � foreign liabilities NDA = Net domestic assets = domestic assets � domestic liabilities With that adjustment, net assets still equal money supply M, under previous assumptions: M = net foreign assets + net domestic assets = NFA + NDA

Slide 63:A More General Central Bank Balance Sheet Example Net foreign assets = 900 Net domestic assets = 100 M = 1,000

Slide 64:A More General Central Bank Balance Sheet Why do central banks borrow (issue liabilities)? Example: Sterilization Bonds Issue local currency debt; use proceeds to buy reserves. As in the simple central balance sheet, this sterilization affects backing ratio and composition of the money supply, without changing the level of the money supply. Leaves domestic credit and the money supply unaffected. Can be done even if domestic assets are zero! A way to acquire reserves in excess of M0. The central bank can have net domestic assets < 0 through issuing these sterilization bonds (central bank-issued bonds), with foreign assets exceeding M, and the backing ratio can then exceed 100%. May be employed if authorities fear large reserve losses under flight from banking system (M2).

Slide 65:The Great Reserve Accumulation in Emerging Markets People�s Bank of China (1995�2006) 1995�2003 Net domestic credit grows slowly while economic expansion leads to a dramatic increase in money demand. Expansion of the money supply was absorbed in reserves and the backing ratio rose from 32% to 56%. 2003�2006 Net domestic credit decreasing, falling below 0% by 2006. Money supply continues to expand, so central bank accumulates massive reserves; backing ratio rises to 109%.

Slide 66:The Great Reserve Accumulation in Emerging Markets Figure 9.10: Sterilization in China By issuing �sterilization bonds,� central banks can borrow from domestic residents to buy more reserves. With sufficient borrowing of this kind, the central bank can end up with negative net domestic credit and reserves in excess of 100% of the money supply. The chart shows how this has happened in China in recent years: from 1995 to 2003, net domestic credit in China was steady, and so reserve growth was almost entirely driven by money demand growth (large movement to the right). From 2003 to 2006, extensive sterilization (large movement down) sent net domestic credit below zero, and, despite still-strong money demand growth, sterilization explains more than half of the reserve growth in the later period. Figure 9.10: Sterilization in China By issuing �sterilization bonds,� central banks can borrow from domestic residents to buy more reserves. With sufficient borrowing of this kind, the central bank can end up with negative net domestic credit and reserves in excess of 100% of the money supply. The chart shows how this has happened in China in recent years: from 1995 to 2003, net domestic credit in China was steady, and so reserve growth was almost entirely driven by money demand growth (large movement to the right). From 2003 to 2006, extensive sterilization (large movement down) sent net domestic credit below zero, and, despite still-strong money demand growth, sterilization explains more than half of the reserve growth in the later period.

Slide 67:The Great Reserve Accumulation in Emerging Markets The situation in China is not unique. Figure 9.11: Reserve Accumulation, 1997�2005 By the end of 2005, reserve holdings worldwide exceeded $4,000 billion, more than double what they were in 1997. Most of the growth occurred in emerging markets, especially Asia. The bulk of these additional reserves were acquired through sterilization and have caused several countries� holdings of foreign exchange reserves to exceed 100% of the monetary base. Source: IMF, International Financial Statistics. Data compiled by Martin Wolf, �Fixing Global Finance,� SAIS Lectures, March 2006. Figure 9.11: Reserve Accumulation, 1997�2005 By the end of 2005, reserve holdings worldwide exceeded $4,000 billion, more than double what they were in 1997. Most of the growth occurred in emerging markets, especially Asia. The bulk of these additional reserves were acquired through sterilization and have caused several countries� holdings of foreign exchange reserves to exceed 100% of the monetary base. Source: IMF, International Financial Statistics. Data compiled by Martin Wolf, �Fixing Global Finance,� SAIS Lectures, March 2006.

Slide 68:The Great Reserve Accumulation in Emerging Markets Causes of the Reserve Accumulation Countries fear a sudden stop (of foreign capital in) or sudden flight (of home capital out). Desire for a larger backing ratio to maintain a stronger peg in response to money demand shocks. More reserves allow the central bank to provide liquidity to the banking system temporarily: reserves can absorb a flight from M2 to foreign currency. After Asian crisis, countries accumulated reserves to build up liquidity in case of another banking crisis. Recall, banking crises and exchange rate crises depend on each other. If the country has sufficient reserves to defend the peg, it is less likely a banking crisis will occur.

Slide 69:Too Much of a Good Thing? From the U.S. perspective Developing countries and emerging markets are accumulating reserves, especially U.S. dollars (U.S. Treasury bonds). This has been one way (often a major way) in which the U.S. finances its current account deficit. These countries use sterilization to prevent changes in the money supply, while accumulating reserves.

Slide 70:Too Much of a Good Thing? From the emerging market perspective Benefit Sterilization and reserve accumulation allows countries to effectively defend the peg, while preventing money supply expansion (and inflation). A form of self-insurance against a crisis triggered by flight from local banks to dollars. Cost Sterilization bonds usually pay higher interest than the interest received on U.S. dollar reserves. Countries face an opportunity cost associated with sterilization.

Slide 71:Too Much of a Good Thing? Key issues and statistics Sterilization bonds in poorer countries pay roughly 12% interest compared with 5% interest on U.S. Treasury bonds. If a crisis has 10% probability, costs 10% of GDP, then �insurance� should cost <1% of GDP. Several countries have accumulated such large reserve holdings that costs are much larger. Reserves held by developing countries doubled in 3 years, reaching $2.9 trillion at the end of 2005.

Slide 72:Summary In the simple model of the central bank balance sheet, the money supply is backed by foreign assets (reserves) and domestic assets (domestic credit). In response to money demand shocks, the central bank buys or sells reserves to defend the peg. The central bank can affect the composition of the money supply through issuing sterilization bonds.

Slide 73:Next: Two Types of Exchange Rate Crises Case 1: Permanently rising domestic credit. Domestic credit rises, draining reserves, forcing balance sheet from fixed to floating line. Once currency floats, exchange rate depreciates because of increase in money supply. Why does this happen? Figure 9.12 (a) Permanently Rising Domestic Credit: Two Types of Exchange Rate Crisis In our model, using the central bank balance sheet diagram, we can see what actions will cause the peg to break. In panel (a), a permanent and ongoing expansion of domestic credit is incompatible with a fixed exchange rate regime because, sooner or later, reserves will be reduced to zero, and then the money supply starts to expand. Figure 9.12 (a) Permanently Rising Domestic Credit: Two Types of Exchange Rate Crisis In our model, using the central bank balance sheet diagram, we can see what actions will cause the peg to break. In panel (a), a permanent and ongoing expansion of domestic credit is incompatible with a fixed exchange rate regime because, sooner or later, reserves will be reduced to zero, and then the money supply starts to expand.

Slide 74:Next: Two Types of Exchange Rate Crises Case 2: Temporary expansion of money supply One-time expansion of money supply, eliminating reserves and forces economy to float. Central bank then contracts money supply to its original value, returning the balance sheet to its initial position. Why does this happen? Figure 9.12 (b) Temporary Expansion of Money Supply: Two Types of Exchange Rate Crisis In our model, using the central bank balance sheet diagram, we can see what actions will cause the peg to break. In panel (b), a temporary expansion of domestic credit and the money supply will lower interest rates and depreciate the exchange rate, even if a reversal of this policy is expected in the future. Figure 9.12 (b) Temporary Expansion of Money Supply: Two Types of Exchange Rate Crisis In our model, using the central bank balance sheet diagram, we can see what actions will cause the peg to break. In panel (b), a temporary expansion of domestic credit and the money supply will lower interest rates and depreciate the exchange rate, even if a reversal of this policy is expected in the future.

Slide 75:LEARNING OBJECTIVES3. How Pegs Break I Inconsistent Fiscal Policies Use a �first generation� crisis model to analyze how fiscal policy affects domestic credit and the money supply with an exchange rate peg. Analyze the effects of fiscal policy on the central bank balance sheet diagram. Understand the mechanics of crises in both the myopic and forward-looking cases. Understand how price adjustment affects the central bank balance sheet, exchange rate, and nominal interest rates during a crisis.

Slide 76:The Basic Problem: Fiscal Dominance A first-generation crisis model explains crises in terms of fiscal policies inconsistent with maintaining an exchange rate peg. Assumptions Y�output is fixed (not central in this model). P�the price level is flexible and determined based on purchasing power parity. E�the exchange rate is fixed if R>0. DEF>0�the government runs a budget deficit because taxes are insufficient to finance spending and the deficit is monetized.

Slide 77:The Basic Problem: Fiscal Dominance Fiscal dominance and the deficit Fiscal dominance: government can require central bank to finance the deficit through buying government bonds issued. Domestic credit expands as the central bank buys bonds: For simplicity, we assume that the rate of growth of domestic credit B is constant:

Slide 78:The Basic Problem: Fiscal Dominance Fiscal dominance and the exchange rate peg Given the assumptions, the fixed exchange rate is not sustainable. With domestic credit expanding, reserves decline. Once reserves run out, the country will be forced to float. In this case, the peg collapses because fiscal and monetary policy decisions are inconsistent with what is needed to hold reserves and maintain the peg.

Slide 79:A Simple Model Deficit monetized, central bank buys govt. bonds. Domestic credit B grows at some fixed rate, �. When the country is eventually forced to float, the money supply, and therefore prices, grow at rate �. The exchange rate depreciates at rate �. Examine two cases. Myopic case. The growth in the deficit is unexpected. Forward-looking case. Investors anticipate the growth of domestic credit and the demise of the peg, and adjust their exchange rate expectations (anticipating the onset of depreciation).

Slide 80:A Simple Model The Myopic Case Like the case studied in Chapter 3. An unexpected increase in the rate of growth in money supply (from 0 to �) at some date. Time 1 (initial conditions) M > B, R > 0 B grows, the central bank buys bonds to finance deficit. M = P = E = 1. Time 1�Time 4 (fixed exchange rate) M remains unchanged. Interest rate, price level, and exchange rate remain unchanged because the money supply is unchanged. B grows at rate = 10%, R>0 declines each period. At Time 4, R reaches zero.

Slide 81:A Simple Model The Myopic Case Time 4 (the peg breaks, forced to float) R = 0, M = B ever after. The country is forced to float. M grows at rate � with the expansion of B (M=B). Price level grows at same rate as the money supply, implying the nominal interest rate increases (Fisher effect). Since the nominal interest rate jumps upward, the price level (and in turn, the exchange rate) must jump upward to clear the money market. M/P has to fall when i jumps up. M doesn�t jump down, so P must jump up. We are assuming flexible prices.

Slide 82:A Simple Model The Myopic Case Time 4 (peg breaks, forced to float) R = 0, M = B. The country is forced to float. M grows at rate � with the expansion of B (M=B). Figure 9.13 (a): An Exchange Rate Crisis Due to Inconsistent Fiscal Policies: Myopic Case In the fixed regime, money supply M is fixed, but expansion of domestic credit B implies that reserves R are falling to zero. Suppose the switch to floating occurs when reserves run out at time 4. Thereafter, the monetary model tells us that M, P, and E will all grow at a constant rate (here 10% per period). The expected rates of inflation and depreciation are now positive, and the Fisher effect tells us that the interest rate must jump up at period 4 (by 10 percentage points). The interest rate increase means that real money demand M/P = L(i)Y falls instantly at time 4. The money supply does not adjust immediately, so this jump in M/P must be accommodated by a jump in prices P. To maintain purchasing power parity, E must also jump at the same time. Hence, myopic investors face a capital loss on pesos at time 4. Figure 9.13 (a): An Exchange Rate Crisis Due to Inconsistent Fiscal Policies: Myopic Case In the fixed regime, money supply M is fixed, but expansion of domestic credit B implies that reserves R are falling to zero. Suppose the switch to floating occurs when reserves run out at time 4. Thereafter, the monetary model tells us that M, P, and E will all grow at a constant rate (here 10% per period). The expected rates of inflation and depreciation are now positive, and the Fisher effect tells us that the interest rate must jump up at period 4 (by 10 percentage points). The interest rate increase means that real money demand M/P = L(i)Y falls instantly at time 4. The money supply does not adjust immediately, so this jump in M/P must be accommodated by a jump in prices P. To maintain purchasing power parity, E must also jump at the same time. Hence, myopic investors face a capital loss on pesos at time 4.

Slide 83:A Simple Model The Myopic Case Time 4 (peg breaks, forced to float). Price level grows at same rate as the money supply, implying the nominal interest rate increases (Fisher effect). Figure 9.13 (b): An Exchange Rate Crisis Due to Inconsistent Fiscal Policies: Myopic Case In the fixed regime, money supply M is fixed, but expansion of domestic credit B implies that reserves R are falling to zero. Suppose the switch to floating occurs when reserves run out at time 4. Thereafter, the monetary model tells us that M, P, and E will all grow at a constant rate (here 10% per period). The expected rates of inflation and depreciation are now positive, and the Fisher effect tells us that the interest rate must jump up at period 4 (by 10 percentage points). The interest rate increase means that real money demand M/P = L(i)Y falls instantly at time 4. The money supply does not adjust immediately, so this jump in M/P must be accommodated by a jump in prices P. To maintain purchasing power parity, E must also jump at the same time. Hence, myopic investors face a capital loss on pesos at time 4. Figure 9.13 (b): An Exchange Rate Crisis Due to Inconsistent Fiscal Policies: Myopic Case In the fixed regime, money supply M is fixed, but expansion of domestic credit B implies that reserves R are falling to zero. Suppose the switch to floating occurs when reserves run out at time 4. Thereafter, the monetary model tells us that M, P, and E will all grow at a constant rate (here 10% per period). The expected rates of inflation and depreciation are now positive, and the Fisher effect tells us that the interest rate must jump up at period 4 (by 10 percentage points). The interest rate increase means that real money demand M/P = L(i)Y falls instantly at time 4. The money supply does not adjust immediately, so this jump in M/P must be accommodated by a jump in prices P. To maintain purchasing power parity, E must also jump at the same time. Hence, myopic investors face a capital loss on pesos at time 4.

Slide 84:A Simple Model The Myopic Case Time 4 (peg breaks, forced to float) If nominal interest rate jumps up, price level (and in turn, the exchange rate) must jump up to clear money market. Figure 9.13 (c): An Exchange Rate Crisis Due to Inconsistent Fiscal Policies: Myopic Case In the fixed regime, money supply M is fixed, but expansion of domestic credit B implies that reserves R are falling to zero. Suppose the switch to floating occurs when reserves run out at time 4. Thereafter, the monetary model tells us that M, P, and E will all grow at a constant rate (here 10% per period). The expected rates of inflation and depreciation are now positive, and the Fisher effect tells us that the interest rate must jump up at period 4 (by 10 percentage points). The interest rate increase means that real money demand M/P = L(i)Y falls instantly at time 4. The money supply does not adjust immediately, so this jump in M/P must be accommodated by a jump in prices P. To maintain purchasing power parity, E must also jump at the same time. Hence, myopic investors face a capital loss on pesos at time 4. Figure 9.13 (c): An Exchange Rate Crisis Due to Inconsistent Fiscal Policies: Myopic Case In the fixed regime, money supply M is fixed, but expansion of domestic credit B implies that reserves R are falling to zero. Suppose the switch to floating occurs when reserves run out at time 4. Thereafter, the monetary model tells us that M, P, and E will all grow at a constant rate (here 10% per period). The expected rates of inflation and depreciation are now positive, and the Fisher effect tells us that the interest rate must jump up at period 4 (by 10 percentage points). The interest rate increase means that real money demand M/P = L(i)Y falls instantly at time 4. The money supply does not adjust immediately, so this jump in M/P must be accommodated by a jump in prices P. To maintain purchasing power parity, E must also jump at the same time. Hence, myopic investors face a capital loss on pesos at time 4.

Slide 85:A Simple Model The Forward-Looking Case Problem with myopic case Investors suffer capital loss on pesos at Time 4. There is a sudden �unexpected� depreciation. But in reality investors know/suspect if country is losing reserves. What if investors observe the deficit growth and immediately realize the peg is not sustainable, and anticipate a crisis? Speculative attack: Adjust exchange rate expectations, selling off their peso-denominated assets in anticipation of depreciation. To see this, we now assume perfect foresight in the model. Initial conditions are the same (Time 1) M > B, R > 0 B grows, the central bank buys government bonds to finance the fiscal deficit. M = P = E = 1.

Slide 86:A Simple Model The Forward-Looking Case Time 1�2 (speculative attack) Investors sell peso assets in exchange for foreign currency. Reserves fall to zero immediately, forcing float at Time 2. Figure 9.14 (a): An Exchange Rate Crisis Due to Inconsistent Fiscal Policies: Perfect Foresight Case Compare with Figure 9-13. If investors anticipate a crisis, they will seek to avoid losses by converting the pesos they are holding to dollars before period 4. The rational moment to attack is at time 2, the point at which the switch from fixed to floating is achieved without any jumps in E or P. Why? At time 2, the drop in money demand (due to the rise in the interest rate) exactly equals the decline in the money supply (the reserve loss), and money market equilibrium is maintained without the price level having to change. Figure 9.14 (a): An Exchange Rate Crisis Due to Inconsistent Fiscal Policies: Perfect Foresight Case Compare with Figure 9-13. If investors anticipate a crisis, they will seek to avoid losses by converting the pesos they are holding to dollars before period 4. The rational moment to attack is at time 2, the point at which the switch from fixed to floating is achieved without any jumps in E or P. Why? At time 2, the drop in money demand (due to the rise in the interest rate) exactly equals the decline in the money supply (the reserve loss), and money market equilibrium is maintained without the price level having to change.

Slide 87:A Simple Model The Forward-Looking Case Interest rate jumps at time 2. Figure 9.14 (b)Figure 9.14 (b)

Slide 88:A Simple Model The Forward-Looking Case Prices, and the exchange rate adjust at time 2. E and P do not jump. No capital gains/losses. Figure 9.14 (c) Figure 9.14 (c)

Slide 89:A Simple Model The Forward-Looking Case: Summary Investors are forward-looking rather than myopic. If they wait until reserves run out they suffer a capital loss. So they attack early, at the moment when all their pesos can be converted to dollars without a loss. Lesson: Even a central bank with a large volume of foreign currency/assets has to worry that these reserves would disappear rapidly if adverse expectations prevailed. This shows why exchange rate collapses are often sudden. And why central banks need to worry about policy credibility.

Slide 90:The Peruvian Crisis of 1986 Origins Early 1980s: Peru faced a weak economy coupled with a heavy debt burden following several years of political upheaval. Peru defaulted on debt, unable to borrow from abroad. This, coupled with low tax revenues during the economic downturn, meant the government relied on the central bank to finance fiscal deficits. Domestic credit roughly doubled each year between 1982�1984 and the Peruvian sol depreciated.

Slide 91:The Peruvian Crisis of 1986 After 1985 election, President Alan Garc�a Perez implemented a fixed exchange rate and worked toward solving fiscal problems. Initially, reforms successful in reducing deficits. But then the deficit grew again. Deficits were monetized, reserves dropped, and the sol was forced to float against the dollar. The sol depreciated rapidly from 250,000 soles/$ (September), to 500,000 soles/$ (November), and finally 1,200,000 (March 1989). Hyperinflation, crisis, departure of Garc�a from office.

Slide 92:The Peruvian Crisis of 1986 The data match the predictions of the forward-looking model. Reserves drained under the peg when the budget deficit opened up, early 1986. Figure 9.15 (b and c): A Crisis in Peru: The Inconsistent Policies of the Garc�a Administration From 1985 to 1986, the Peruvian government implemented a fixed exchange rate regime, but government budget problems required significant monetization of budget deficits. Monetary and fiscal policies were inconsistent: a peg was in place, but domestic credit grew exponentially (note that the exchange rate and domestic credit are shown on logarithmic scales). The central bank lost three-quarters of its reserves in two years, and the peg had to be abandoned. Source: IMF, International Financial Statistics. Figure 9.15 (b and c): A Crisis in Peru: The Inconsistent Policies of the Garc�a Administration From 1985 to 1986, the Peruvian government implemented a fixed exchange rate regime, but government budget problems required significant monetization of budget deficits. Monetary and fiscal policies were inconsistent: a peg was in place, but domestic credit grew exponentially (note that the exchange rate and domestic credit are shown on logarithmic scales). The central bank lost three-quarters of its reserves in two years, and the peg had to be abandoned. Source: IMF, International Financial Statistics.

Slide 93:The Peruvian Crisis of 1986 Domestic credit expands; currency eventually forced to float. Figure 9.15 (a): A Crisis in Peru: The Inconsistent Policies of the Garc�a Administration From 1985 to 1986, the Peruvian government implemented a fixed exchange rate regime, but government budget problems required significant monetization of budget deficits. Monetary and fiscal policies were inconsistent: a peg was in place, but domestic credit grew exponentially (note that the exchange rate and domestic credit are shown on logarithmic scales). The central bank lost three-quarters of its reserves in two years, and the peg had to be abandoned. Source: IMF, International Financial Statistics. Figure 9.15 (a): A Crisis in Peru: The Inconsistent Policies of the Garc�a Administration From 1985 to 1986, the Peruvian government implemented a fixed exchange rate regime, but government budget problems required significant monetization of budget deficits. Monetary and fiscal policies were inconsistent: a peg was in place, but domestic credit grew exponentially (note that the exchange rate and domestic credit are shown on logarithmic scales). The central bank lost three-quarters of its reserves in two years, and the peg had to be abandoned. Source: IMF, International Financial Statistics.

Slide 94:A Simple Model Expectations and the Critical Level of Reserves In the speculative attack/forward-looking model, investors watch the change (growth rate) of domestic credit to determine whether the peg is sustainable, and for how long. The critical level of reserves when the attack occurs depends on: the sensitivity of money demand to changes in the interest rate, and the future expected growth in domestic credit. Note: a shift in expectations is sufficient to trigger a crisis.

Slide 95:A Simple Model Determining the critical level of reserves. Suppose a 1% point increase in nominal interest rate causes a ?% decrease in real money balances. The Fischer effect says that at the critical point of speculative attack, ? i = �. So money supply changes by: Let Rc denote critical level of reserves at time of the speculative attack. Result (expectations matter):

Slide 96:Summary Implications from first generation crisis model Existence of inconsistent fiscal policies causes the collapse of the exchange rate peg. Inconsistent fiscal policies allow for the expansion of domestic credit and draining of reserves, forcing the country to float. In the forward-looking model, it is not the actual fiscal policies that matter, but rather investors� expectations of fiscal policy.

Slide 97:LEARNING OBJECTIVES4. How Pegs Break II Contingent Monetary Policies Use �second generation model� to understand contingent commitment and discuss how this affects expectations. Understand the importance of investors� expectations, monetary policy credibility, and output costs in defending the peg. Analyze how a change in the foreign interest rate using the IS/LM/FX diagrams. Explain how the foreign interest rate is linked to the costs and benefits of pegs.

Slide 98:The Basic Problem: Contingent Commitment The second generation crisis model applies to situations where a crisis occurs, despite appropriate policy decisions. Exchange rate pegs involve a contingent commitment by policy makers. Investors know they are conditions under which a government will abandon an exchange rate peg. Model is based on the idea of multiple equilibria, determined by investors� self-fulfilling expectations.

Slide 99:The Basic Problem: Contingent Commitment Britain and Germany, 1992 Britain forced to raise interest rates to maintain the ERM peg, pushing Britain into a recession. Prior to this shock, the peg was credible, with interest rates relatively low in Britain and Germany (i=i*). However, once interest rates rise, investors expect Britain more likely to abandon the peg. But if peg no longer credible. Investors demand a currency premium given expected depreciation (i>i*). This further drives up Britain�s interest rate, further increasing the economic pain and (hence) likelihood of the peg�s collapse. The expectation that Britain will abandon the peg forces Britain to float. Self-fulfilling expectations.

Slide 100:A Simple Model Overview Cost of maintain the peg assumed to be the deviation in output caused by remaining on the fixed exchange rate regime (the output gap).

Slide 101:A Simple Model Small Recession, Peg Credible Economy experiences small recession, so the output gap creates some positive cost associated with the peg. Figure 9.16 (a): Contingent Commitments and the Cost of Maintaining a Peg This figure describes how the IS-LM-FX equilibrium changes as demand shocks occur and as the credibility of the peg weakens. The economy is pegging at a fixed exchange rate E-. In panel (a), the economy is at IS-LM equilibrium at point 1, with the FX market at point 1'. Output is a little below desired output, so the cost of pegging c1 is small. Figure 9.16 (a): Contingent Commitments and the Cost of Maintaining a Peg This figure describes how the IS-LM-FX equilibrium changes as demand shocks occur and as the credibility of the peg weakens. The economy is pegging at a fixed exchange rate E-. In panel (a), the economy is at IS-LM equilibrium at point 1, with the FX market at point 1'. Output is a little below desired output, so the cost of pegging c1 is small.

Slide 102:A Simple Model Large Recession, Peg Credible Central bank contracts money supply to maintain interest rate parity, i = i* and exchange rate peg. Figure 9.16 (b): Contingent Commitments and the Cost of Maintaining a Peg This figure describes how the IS-LM-FX equilibrium changes as demand shocks occur and as the credibility of the peg weakens. The economy is pegging at a fixed exchange rate E-. In panel (b), there is an adverse shock to domestic demand, and the IS curve shifts in. LM shifts in, too, to maintain the peg. The new IS-LM equilibrium is at point 2, with FX market equilibrium at point 2' (same as 1'). The cost of pegging c2 is higher. Figure 9.16 (b): Contingent Commitments and the Cost of Maintaining a Peg This figure describes how the IS-LM-FX equilibrium changes as demand shocks occur and as the credibility of the peg weakens. The economy is pegging at a fixed exchange rate E-. In panel (b), there is an adverse shock to domestic demand, and the IS curve shifts in. LM shifts in, too, to maintain the peg. The new IS-LM equilibrium is at point 2, with FX market equilibrium at point 2' (same as 1'). The cost of pegging c2 is higher.

Slide 103:A Simple Model Large Recession, Peg Credible Cost is sufficiently small that investors view the peg as credible. If the peg is credible, the output gap increases as the size of the adverse shock increases.

Slide 104:A Simple Model Large Recession, Peg Not Credible Central bank contracts money supply by even larger amount. Cost of maintaining the peg is sufficiently large that investors expect a future expansion, demanding a currency premium to compensate for increased exchange rate risk. Expected depreciation shifts IS to the right. Central bank response to defend the peg implies the LM curve must shift to the left�contracting the money supply to increase the interest rate. Demand (and Y) must be lower at same E and higher i.

Slide 105:A Simple Model Large Recession, Peg Not Credible Central bank contracts money supply by larger amount: currency premium required by investors. Figure 9.16 (c): Contingent Commitments and the Cost of Maintaining a Peg This figure describes how the IS-LM-FX equilibrium changes as demand shocks occur and as the credibility of the peg weakens. The economy is pegging at a fixed exchange rate E-. Panel (c) shows that if the country wants to attain full employment output next period, it must move to point 4, shifting the LM curve out and allowing the FX market to settle at point 4' with the exchange rate depreciating to Efloat. The peg would still be in operation today, but, by definition, it would no longer be credible if such a policy change were anticipated. Because of the lack of credibility, investors would insist on receiving a positive currency premium today, and the home interest rate would rise to i3, squeezing demand even more and moving the IS-LM equilibrium to point 3 and the FX market to point 3'. Now the cost of pegging c3 is even higher: having a noncredible peg is more costly than having a credible peg. Figure 9.16 (c): Contingent Commitments and the Cost of Maintaining a Peg This figure describes how the IS-LM-FX equilibrium changes as demand shocks occur and as the credibility of the peg weakens. The economy is pegging at a fixed exchange rate E-. Panel (c) shows that if the country wants to attain full employment output next period, it must move to point 4, shifting the LM curve out and allowing the FX market to settle at point 4' with the exchange rate depreciating to Efloat. The peg would still be in operation today, but, by definition, it would no longer be credible if such a policy change were anticipated. Because of the lack of credibility, investors would insist on receiving a positive currency premium today, and the home interest rate would rise to i3, squeezing demand even more and moving the IS-LM equilibrium to point 3 and the FX market to point 3'. Now the cost of pegging c3 is even higher: having a noncredible peg is more costly than having a credible peg.

Slide 106:A Simple Model The Costs and Benefits of Pegging Costs and benefits of pegging are plotted as a function of the costs of pegging when the peg is credible. Benefits of the peg are fixed and given with b > 0. Cost of credible peg is given by 45-degree line.

Slide 107:A Simple Model The Costs and Benefits of Pegging Zone I: Peg Zone II: Peg OR Depreciate Zone III: Depreciate Figure 9.17: Contingent Policies and Multiple Equilibria Building on Figure 9-16, this figure shows how the costs of pegging depend on whether the peg is credible, and how that affects the game between the authorities and investors. The costs of pegging when the peg is credible are shown on the horizontal axis. To measure these costs on the vertical axis, we can read off from the 45-degree line. We know that the costs of pegging when the peg is not credible will be even higher. Costs rise when investors do not believe in the peg. We assume the government thinks the benefits of pegging (for example, lower trade costs) are fixed and equal to B. In this world, the peg is always credible in Zone I, where benefits always exceed costs: the government never wants to depreciate and investors know it. The peg is always noncredible in Zone III, where costs always exceed benefits: the government always wants to depreciate and investors know it. Zone II is the gray area: if investors believe the peg is credible, costs are low and the peg will hold; if investors believe the peg is noncredible, costs are higher and the peg will break. Figure 9.17: Contingent Policies and Multiple Equilibria Building on Figure 9-16, this figure shows how the costs of pegging depend on whether the peg is credible, and how that affects the game between the authorities and investors. The costs of pegging when the peg is credible are shown on the horizontal axis. To measure these costs on the vertical axis, we can read off from the 45-degree line. We know that the costs of pegging when the peg is not credible will be even higher. Costs rise when investors do not believe in the peg. We assume the government thinks the benefits of pegging (for example, lower trade costs) are fixed and equal to B. In this world, the peg is always credible in Zone I, where benefits always exceed costs: the government never wants to depreciate and investors know it. The peg is always noncredible in Zone III, where costs always exceed benefits: the government always wants to depreciate and investors know it. Zone II is the gray area: if investors believe the peg is credible, costs are low and the peg will hold; if investors believe the peg is noncredible, costs are higher and the peg will break.

Slide 108:A Simple Model The Costs and Benefits of Pegging Zone I Unique equilibrium: peg. Whether the peg is credible or not, the benefits of maintaining the peg outweigh the costs, so peg will hold. Zone III Unique equilibrium: depreciate. Whether the peg is credible or not, the costs of maintaining the peg outweigh the benefits, so the monetary authority will float the currency.

Slide 109:A Simple Model The costs and benefits of pegging Zone II Two equilibria: peg or depreciate. Peg is credible. The benefits of pegging outweigh the costs, so the peg is maintained. Peg is not credible. The costs of pegging outweigh the costs, so the monetary authority floats the currency. When the economy is in Zone II, the equilibrium outcome hinges on investors� expectations. This is known as a self-confirming equilibrium.

Slide 110:The Man Who Broke the Bank of England In practice, instability created by multiple equilibria and self-fulfilling expectations can exceed output losses examined in the model. The model above assumed the switch from a peg to float happens gradually. In reality, this can happen quickly, so the currency premium expands rapidly, forcing the government to abandon the peg more quickly. During the 1992 ERM crisis, Sweden�s overnight interest rate climbed from 75% on September 8 to 500% on September 19.

Slide 111:The Man Who Broke the Bank of England Individual traders cannot influence forex market. But large traders can move market expectations. Example: the Quantum Fund and the ERM crisis When the pound depreciated, the fund made billions, using the appreciated DM to repay pound-denominated debt. The British government did not implement the sharp interest rate hikes Sweden used earlier to defend its peg. Britain abandoned the peg, after spending �4 billion trying to defend it. George Soros was betting on the pound depreciation.

Slide 112:Summary The exchange rate peg involves a contingent commitment by the government, so that investors� expectations about the exchange rate, and hence the government�s ability to defend the peg. In this way, investors� expectations can affect real economic outcomes. Whether or not the currency will suffer from a speculative attack, depends on investors� self-fulfilling expectations.

Slide 113:Conclusions Can We Prevent Crises? If a speculative attack can be caused by a change in expectations, then is there any way to defend exchange rate pegs? Possible solutions. Capital controls. Avoidance of intermediate exchange rate regimes. Float. Hard pegs. Improve policy institutions and financial markets. International lender of last resort. Self-insurance.

Slide 114:Can We Prevent Crises? Possible Solutions. The case for capital controls Capital controls restrict the flow of foreign currency trading. Controls are hard to implement in practice, especially when imposed during a speculative attack. The case against intermediate regimes Intermediate regimes are very risky because investors are less likely to view the peg as credible. The corners hypothesis or missing the middle recommends that countries should commit to one of the three limitations imposed by the trilemma.

Slide 115:Can We Prevent Crises? Possible Solutions. The case for floating Without an exchange rate peg, countries need not worry about exchange rate crises. There may be compelling reasons to establish a peg, especially in developing countries and emerging markets. The case for hard pegs If a country wants to maintain a peg, then hard pegs or a currency board system are the best ways to maintain credibility, reducing the costs of a potential crisis. Very few countries have adopted this approach and even hard pegs can break because they still involve a contingent commitment.

Slide 116:Conclusions Can We Prevent Crises? Possible Solutions. The case for improving the institutions of macroeconomic policy and financial markets Establishing sound financial institutions and central bank transparency helps reduce uncertainty. These goals are important to most governments but take a long time to accomplish. With a stronger banking and financial system, the costs of crises can be mitigated. The case for an international lender of last resort If countries have the ability to borrow foreign reserves, then they could better defend the exchange rate peg. The International Monetary Fund (IMF) can lend foreign currency to countries to help defend the peg during a crisis.

Slide 117:Conclusions Can We Prevent Crises? Possible Solutions. The case for an international lender of last resort In practice, the IMF may impose unpopular loan conditions and require fundamental policy changes, such as stricter control of fiscal deficits.

Slide 118:Conclusions Can We Prevent Crises? Possible Solutions. The case for self-insurance If none of the options above appeal or are possible, then what can a country with an exchange rate peg do? We can observe what they are doing�amassing foreign reserves to avert exchange rate crises

Slide 119:Key Points An exchange rate crisis is defined as a sudden and dramatic depreciation in the currency, following the collapse of a fixed exchange rate regime. Crises are common and carry both economic and political costs. To defend the exchange rate peg, central banks must have sufficient foreign currency reserves.

Slide 120:Key Points In a simple model of the central bank balance sheet, the money supply is divided between domestic credit and reserves. The central bank can use reserves to defend the peg in response to money demand shocks. The central bank can adjust the composition of the money supply, affecting the backing ratio. In a general model of the central bank balance sheet, the bank can provide domestic credit to insolvent or illiquid banks.

Slide 121:Key Points In a first generation crisis model, crises are caused by inconsistent fiscal policy. Budget deficits expand domestic credit until reserves are depleted, forcing the country to float. When investors are myopic, the reserves gradually decline, then the currency gradually depreciates. If investors are forward looking, the crisis will happen quickly, as investors anticipate future deficits.

Slide 122:Key Points In a second generation crisis model, crises are caused by changes in investors� expectations, even when policy is appropriate. The exchange rate peg involves a contingent commitment by the central bank. Once investors believe the costs of the peg outweigh the benefits, a speculative attack occurs, forcing the country to float. The model permits multiple equilibria, based on investors� expectations.