exchange-rate systems and currency crises © 2011 cengage learning. all rights reserved. may not be...

Exchange-Rate Systemsand Currency Crises

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password protected website for classroom use‐ 1

PowerPoint slides prepared by:Andreea ChiritescuEastern Illinois University


Exchange-rate arrangements of IMF members, 2008TABLE 15.1


Choosing an exchange-rate systemTABLE 15.2

Countries can adopt only two of the following three policies: free capital flows, a fixed exchange rate, and an independent monetary policy.


FIGURE 15.1


Key currencies: currency composition of official foreign exchange reserves of the member countries of the international monetary fund, 2008

TABLE 15.3

To defend the official exchange rate of $2.80 per pound, the central bank must supply all of the nation’s currency that is demanded at the official rate and demand all of the nation’s currency that is supplied to it at the official rate. To prevent a dollar depreciation, the central bank must purchase the excess supply of dollars with an equivalent amount of pounds. To prevent a dollar appreciation, the central bank must purchase the excess supply of pounds with an equivalent amount of dollars.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password protected website for classroom use‐ 6

Exchange-rate stabilization under a fixed exchange-rate system

FIGURE 15.2


Advantages and disadvantages of fixed exchange rates and floating exchange rates

TABLE 15.4

Advantages Disadvantages

Fixed exchange rates

Floating exchange rates

Simplicity and clarity of exchange-rate target Automatic rule for the conduct of monetary policyKeeps inflation under control

Continuous adjustment in the balance of paymentsOperate under simplified institutional arrangementsAllow governments to set independent monetary and fiscal policies

Loss of independent monetary policyVulnerable to speculative attacks

Conducive to price inflationDisorderly exchange markets can disrupt trade and investment patternsEncourage reckless financial policies on the part of government

Under a floating exchange-rate system, continuous changes in currency values restore payments equilibrium at which the quantity supplied and quantity demanded of a currency are equal. Starting at equilibrium point A, an increase in the demand for francs leads to a depreciation of the dollar against the franc; conversely, a decrease in the demand for francs leads to an appreciation of the dollar against the franc.


Market adjustment under floating exchange ratesFIGURE 15.3

Under this system, central bank intervention is used to stabilize exchange rates in the short term; in the long term, market forces are permitted to determine exchange rates.


Managed floating exchange ratesFIGURE 15.4

In the absence of international policy coordination, stabilizing a currency’s exchange value requires a central bank to initiate (a) an expansionary monetary policy to offset an appreciation of its currency, and (b) a contractionary monetary policy to offset a depreciation of its currency.


Exchange-rate stabilization and monetary policyFIGURE 15.5


Examples of currency crisesTABLE 15.5Mexico, December 1994–1995. Mexico’s central bank maintained the value of the peso within a band that depreciated four percent a year against the U.S. dollar. In order to reduce interest rates on its debt, the Mexican government in April 1994 began issuing debt linked to the dollar. The amount of this debt soon exceeded the central bank’s falling foreign-exchange reserves. Unrest in the province of Chiapas led to a speculative attack on the peso. Although the government devalued the peso by 15 percent by widening the band, the crisis continued. The government then let the peso float; it depreciated from 3.46 per dollar before the crisis to more than 7 per dollar. To end the crisis, Mexico received pledges for $49 billion in loans from the U.S. government and the IMF. Mexico’s economy suffered a depression and banking problem that led to government rescues.

Russia, 1998. The Russian government was paying high interest rates on its short-term debt. Falling prices for oil, a major export, and a weak economy also contributed to speculative attacks against the ruble, which had an official crawling band with the U.S. dollar. Although the IMF approved loans for Russia of about $11 billion and the Russian government widened the band for the ruble by 35 percent, the crisis continued. This crisis led to the floating of the ruble and its depreciation against the dollar by about 20 percent. Russia then went into recession and experienced a burst of inflation. Many banks became insolvent. The government defaulted on its ruble-denominated debt and imposed a moratorium on private-sector payments of foreign debt.


Examples of currency crisesTABLE 15.5

Turkey, 2001. The Turkish lira had an IMF-designed official crawling peg against the U.S. dollar. In November 2000, rumors about a criminal investigation into ten government-run banks led to a speculative attack on the lira. Interbank interest rates rose to 2,000 percent. The central bank then intervened. Eight banks became insolvent and were taken over by the government. The central bank’s intervention had violated Turkey’s agreement with the IMF, yet the IMF lent Turkey $10 billion. In February 2001, a public dispute between the president and prime minister caused investors to lose confidence in the stability of Turkey’s coalition government. Interbank interest rates rose to 7,500 percent. Thus, the government let the lira float. The lira depreciated from 668,000 per dollar before the crisis to 1.6 million per dollar by October 2001. The economy of Turkey stagnated and inflation skyrocketed to 60 percent.

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