CRISES AND THE FLEXIBLE PRICE MONETARY MODEL Saranis Kalyviis
Currency Crises In fixed exchange rae regimes, counries rarely abandon he regime volunarily. In mos cases, raders (or speculaors) exchange domesic currency for foreign one a he fixed rae, leading o an exhausion of reserves and o a new floaing- rae ha is depreciaed ( currency crisis ). How is a currency crisis iniiaed? Inconsisen fundamenals In he 1970's - 1980's a series of crises affliced Lain America. The underlying problem was ha counries were running fiscal deficis financed by expanding domesic credi whils simulaneously fixing he exchange rae. These policies are inconsisen. Expecaions abou fuure depreciaion During he 1990's here were a number of occasions in which foreign exchange dealers under panic sold paricular currencies (because hey fel ha a devaluaion is imminen) causing large depreciaion's of nominal exchange raes by heir own behavior. 1
Firs-Generaion Models The analysis is based on he he flexible price moneary model: s = m φ y + λi p + λe ds d The firs explanaion focuses primarily on he money supply and so simplify we use he following 'reduced form' of he moneary model: s = m + E ( s ) λ (1) m + = c r (2) c = domesic credi, = r foreign exchange reserves, s = ds d 2
Domesic Policy Suppose ha o finance a fiscal defici (excess of governmen expendiure over ax revenue) domesic credi grows a a consan rae: c = µ (3) So ha a ime : c c + µ = 0 (3)' 3
Exernal/Exchange Rae Policy Now suppose he governmen fixes he exchange rae. The expeced depreciaion of he exchange rae equals he expeced change in fundamenals. Since he only fundamenal is he money supply E ( s) = E( f ) = E( m) If he exchange rae is credibly fixed i canno be expeced o depreciae: E ( s) = E( m) = 0 Subsiuion of he above ino (1) yields he fixed rae, s = m (4) To fix he exchange rae he governmen mus fix he money supply. 4
However o finance he fiscal defici he governmen expands domesic credi. For he money supply and exchange rae o be fixed reserves mus be falling by he same amoun. E ( m) = E( c) + E( r) = 0 E ( r) = E( c) = µ (5) Under a rising domesic credi: c i capial ouflow s > 0 So, he only way o keep he exchange rae fixed is: r = c m = m s = 0 The governmen prevens he ineres rae from falling by buying up he excess domesic currency using is foreign reserves. Ulimaely running down foreign reserves finances he defici. 5
From (5): r r µ = 0 (5)' If he governmen has limied reserves hey will run ou and he fixed exchange rae will collapse. The ime ha reserves run ou can be calculaed by solving: rt N = N r0 µ T = 0 r T 0 N = (6) µ The lifeime of he fixed rae equals he size of he iniial reserve sock divided by he rae reserves are los. Example: if he iniial reserve sock were 10 imes he rae of domesic credi expansion he fixed rae would las for 10 years. 6
Figure 1. The money supply and he exchange rae m c = m r 0,c 0 m Time s s s = m T N Time 7
The Jump Depreciaion There is a problem wih Figure 1 hough. Up unil T N he expeced depreciaion is zero and he exchange rae equals, s = m A T N he exchange rae sars o depreciae and he expeced depreciaion jumps from zero o µ: E ( s) = E( m) = E( c) = µ From (1) he exchange rae afer reserves run ou is s = m λµ (7) + Exacly a ime i is, s = m (8) The pah of he exchange rae is no ha shown in Figure 1! 8
Figure 2. Pah of he exchange rae wih jump depreciaion s floaing s λµ T TN Time 9
Bu wha is wrong wih his? A he ime ha reserves run ou he exchange rae jump depreciaes by λµ. Currency raders suffer a predicable capial loss equal o λµ imes he amoun of domesic currency held. This violaes he no-arbirage condiion. Wha really happens? Consider he UIP relaionship i = ds i + E d Whils he exchange rae is fixed he expeced depreciaion is zero and, i = i A he ime he fixed rae collapses he expeced depreciaion jumps o µ and he ineres rae o i = i + µ 10
Now consider he domesic money marke. m p = φy λi An increase in he ineres rae of µ reduces money demand by λµ. So ha a he ime of collapse here is a discree reducion in money demand of, m d = λµ How does his ake place? If currency raders do nohing a he ime of collapse hey suffer a discree capial loss equal o λµ imes currency held. To avoid his hey aack (swap domesic currency for reserves) he domesic currency before reserves would oherwise run ou. The size of his aack is jus sufficien o eliminae he jump. Tha is he domesic currency in circulaion is reduced by an amoun ha appreciaes he exchange rae by λµ relaive o he no-aack scenario. 11
The fixed rae collapses wih a speculaive aack ha wipes ou λµ of reserves. This aack occurs when: r = λµ (9) A speculaive aack wipes ou all remaining reserves. The ime he aack occurs solves: r T 0 = r µ T = λµ T = r0 µ λ (10) which is smaller han r T 0 N = given by (6). µ 12
Summary of he firs-generaion model The roo cause of he problem is an inconsisency beween domesic policy and exchange rae policy. The linkage beween fiscal deficis and moneary policy are emphasised especially for Lain American economies. The same scenario could apply o wider se of fundamenals. A currency crisis is bound o end in a speculaive aack as raders seek o avoid capial losses. Collapse is no ineviable. If fundamenals are no inconsisen hen he exchange rae does no collapse. This model worked well up unil he 1990's. 13
The European Moneary Sysem The EMS was an inermediae sysem. I allowed exchange raes o flucuae wihin cerain symmeric limis. s s u s l f 14
The exchange rae is free o move inside he limis bu would be prevened from passing he limis by appropriae adjusmen of he money supply and ineres raes. Inervenion was mean o be bilaeral bu in pracice was unilaeral. Given symmeric limis if he /DM rae was a s u he DM/ rae would be a s l. Boh Germany and he UK were mean o inervene bu in pracice only he counry whose currency was a s u inervened. The sysem funcioned as a DM zone. The DM ended o appreciae relaive o he majoriy of oher currencies. This mean he oher counries had o operae high ineres raes. Why were hey happy o do his? Because hey believed i would give heir moneary policy a similar credibiliy o Germany. In effec hey viewed his as a way of appoining a conservaive cenral banker. 15
The EMS Crisis In 1990 German reunificaion occurred amids he backdrop of a deep recession afflicing Wesern Europe. In deciding o swap 1 Osermark for 1 DM Chancellor Kohl boosed purchasing power bu no producive capaciy in he old Eas Germany. The resul was inflaion. This creaed a conflic beween exernal and inernal objecives. Germany waned o lower inflaion by ighening he money supply and raising ineres raes. The majoriy of oher counries waned o offse he recession by lowering ineres raes. UIP: i = ds i + E d Germany waned o increase i whils oher counries waned o lower i. The currency markes sared o expec a discree depreciaion of currencies relaive o he DM. Bu he expecaion of depreciaion increases he domesic ineres rae sill furher. Since hese oher counries would have preferred o lower ineres raes his jus makes he depreciaion sill more likely. The sysem los credibiliy and even as in he case of he UK an economy did raise he ineres rae his did no pacify currency dealer's who coninued o exchange 's and oher currencies for DM's. 16
The key poin is ha expecaions are self-fulfilling. Evenually he cycle becomes oo much and he EMS collapsed in 1992/3. Is his consisen wih he firs generaion model? A conracion of domesic credi in Germany is equivalen o an expansion in he home counry. I did end in a big aack and massive losses of reserves. (G. Soros was repued o have made more han 1 billion serling). However: The UK did no run ou of reserves. Moreover if Germany had been willing o inervene on behalf of he hen no size of aack would have been sufficien o offse he collapse. The self-fulfilling naure of expecaions was imporan. In paricular even hough mos counries ook he appropriae acions heir exchange raes sill collapsed. The problem is he inconsisency beween inernal and exernal objecives. Germany waned he DM o appreciae and he UK, Ialy e al waned heir currencies o depreciae. 17
Self-fulfilling aacks and policy The firs generaion model of currency crises cerainly did no cover all he feaures of he EMS crisis. In paricular he idea ha self-fulfilling aacks could lead fixed (or managed) exchange raes o collapse even if fundamenals were consisen wih he regime is imporan. A Speculaive Game Assumpions: Traders have 6 unis of domesic currency each. Trading coss are 1 per ransacion (for each one) If an aack succeeds he domesic currency is devalued by 50%. So if a rader sells all heir currency and he aack succeeds hey gain (in domesic currency): (6X0.5)-1= 3-1 = 2 18
Consider hree differen games based on having differen socks of foreign exchange reserves (or, oherwise, differen willingness of a counry o defend he exchange rae) 1 High Reserve Game R=20 2 Hold Sell Hold 0,0 0,-1 Sell -1,0-1,-1 boh speculaors have an ineres o remain inacive (if he buy, hey will pay he ransacion cos wihou any profi) 1 Low Reserve Game R= 6 2 Hold Sell H 0,0 0,2 S 2,0 1/2,1/2 boh speculaors will profi from buying now (since he foreign reserves will cerainly be depleed!) 1 Inermediae Reserve Game R= 10 2 Hold Sell H 0,0 0,-1 S -1,0 3/2, 3/2 if boh buy (each one 10/2=5 unis) hey will gain, bu if only one does, he will suffer a loss relaive o remaining inacive, so he oucome is uncerain (muliple equilibria!) 19
Mechanisms ha migh give rise o self-fulfilling aacks Example 1: Temporary Capial Conrols I is ofen suggesed ha o preven currency crises a Tax on Foreign Exchange ( Tobin Tax ) dealings should be applied. Suppose his Tax is emporary and is applied only in imes of crisis. (Noice policy is coningen on here being a crisis) If speculaors wai for he crisis hen eiher hey: Hold domesic currency and suffer capial losses, or Sell he currency and pay he Tax. Why no ry o avoid he Τax by selling he currency before he crisis? Bu if everyone does his i simply leads o an earlier crisis. The measure designed o preven he crisis migh acually cause he crisis. If he Tobin Tax is permanen his argumen does no apply. The key poin abou his is ha policy is coningen on here being a crisis. 20
We now reconsider he UK in he ERM crisis. Prior o he collapse he UK ran a igh moneary policy (impor high ineres raes from Germany) o defend he /DM rae. However, once he sysem collapsed he UK expanded he money supply, a policy ha was no consisen wih he EMS. Again noe ha policy was coningen on he exisence of he EMS. How would policy coningency change he earlier model? Le he pre-crisis rae of moneary growh be µ 0 bu if an aack is successful he rae of moneary growh may rise o µ 1. Τhe rae of domesic credi growh is coningen on he aack. This complicaes maers because i creaes wo possibiliies for he exchange rae should he fixed rae collapse. 21
Figure 3: Policy Coningency and Speculaive Aack s s ( µ 1 ) s ( µ 0 ) T A T B Time There is no raional aack before <T A T B is he laes ime a which a raional aack can occur T A < < TB an aack may or may no occur. A coordinaed aack will be successful. Suppose µ 0 = 0. Pre-crisis fundamenals are consisen wih he mainenance of he fixed rae forever. However he possibiliy ha a successful aack migh lead o an inconsisen pos-collapse policy can rigger an aack. Clearly he closer we are o T A he more likely is he aack. 22
A Problem wih he basic model: "Serilisaion" of he Money supply In he Mexican crisis of 1994 he moneary auhoriy serilised he money supply during he crisis. This means ha a he ime of he crisis he cenral bank expanded domesic credi o offse he money supply effecs of he reserve loss. This means he money supply of he shadow rae equals he money supply of he fixed rae. and s = + δ s m = λµ + m + δ s s = λµ > 0 If he governmen is expanding domesic credi he exchange rae will always depreciae in he pos collapse regime. The raional aack is jus sufficien o reduce he money supply sufficienly o force he domesic ineres rae up enough o compensae remaining asse holders for he depreciaion. If he money supply is consan he ineres rae will no rise and he exchange rae will always jump depreciae. When does he raional aack occur now? I occurs he insan he fixed rae is se up and equals he iniial sock of reserves. Despie his he exchange rae sill jump depreciaes. 23
Summary There are wo sors of currency crises depending on wheher hey are riggered by inconsisen fundamenals or beliefs by speculaors. One aspec deals wih an anicipaed change in fundamenals, which is inconsisen wih he curren fixed exchange rae. Speculaors realize ha hey will suffer expeced capial losses and aach he currency now, leading o he collapse a he ime of realizaion (and no of acual policy change). Anoher aspec deals wih he self-fulfilling characer of currency crises. Speculaors may aack a any ime hey believe ha he fixed rae regime is no susainable, which will ex pos confirm heir expecaions. Cenral Banks have various ools o preven speculaive aacks: he level of heir reserves is no officially disclosed, shor-erm ineres raes may rise sharply o preven speculaive borrowing, and inernaional coordinaion beween CBs may be agreed and announced in order o raise he pool of reserves and heir credibiliy, and show heir willingness in defending he exchange rae. There are many oher aspecs of currency crises depending on he naure of expecaions, he pos-collapse regime ec. 24