Download chapter-15

Exchange-Rate Systems
and Currency Crises
PowerPoint slides prepared by:
Andreea Chiritescu
Eastern Illinois University
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distributed with a certain product or service or otherwise on a password‐protected website for classroom use
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TABLE 15.1 Exchange-rate arrangements of IMF members, 2008
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TABLE 15.2 Choosing an exchange-rate system
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FIGURE 15.1
Countries can adopt only two of the following three policies: free capital flows, a fixed
exchange rate, and an independent monetary policy.
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TABLE 15.3 Key currencies: currency composition of official
foreign exchange reserves of the member countries
of the international monetary fund, 2008
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FIGURE 15.2 Exchange-rate stabilization under a fixed
exchange-rate system
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.
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TABLE 15.4 Advantages and disadvantages of fixed
exchange rates and floating exchange rates
Advantages
Disadvantages
Fixed exchange
rates
Simplicity and clarity of exchangerate target
Automatic rule for the conduct of
monetary policy
Keeps inflation under control
Loss of independent monetary
policy
Vulnerable to speculative
attacks
Floating exchange
rates
Continuous adjustment in the
balance of payments
Operate under simplified institutional
arrangements
Allow governments to set
independent monetary and fiscal
policies
Conducive to price inflation
Disorderly exchange markets
can disrupt trade and
investment patterns
Encourage reckless financial
policies on the part of
government
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FIGURE 15.3 Market adjustment under floating exchange rates
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.
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FIGURE 15.4 Managed floating exchange rates
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.
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FIGURE 15.5 Exchange-rate stabilization and monetary policy
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.
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TABLE 15.5 Examples of currency crises
Mexico, 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.
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TABLE 15.5 Examples of currency crises
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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