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Solution for International Macroeconomics 3rd Edition Chapter 9, Problem 1

by Robert C. Feenstra, Alan M. Taylor, James Taylor
285 Solutions 11 Chapters 40213 Studied ISBN: 9781429278430 Economics 5 (1)

Chapter 9, Problem 1 : 1.The economic costs of currency crises appear to...

1.The economic costs of currency crises appear to be larger in emerging markets and developing countries, than they are in advanced countries. Discuss why this is the case, citing the interaction between the currency crisis and the financial sector. In what ways do currency crises lead to banking crises in these countries? In what ways do banking crises spark currency crises?

 

Step-By-Step Solution

1.Answer: Developing countries and emerging markets are less likely to have sound institutions of macroeconomic policy and financial markets. Also, these countries are more likely to adopt a fixed exchange rate regime because the benefits are relatively greater than those in advanced economies. The situation is exacerbated by the fact that private sector, particularly banks, as well as the governments in these countries borrow in the international markets in dollars, and thus accumulate dollar-denominated liabilities. Because of all the above-mentioned factors, these countries are more likely to suffer from all three types of crises: exchange rate, banking, and sovereign default. Therefore, there is potential for feedback between the three crises, resulting in twin crises or triple crises. Currency crises can lead to financial crises because changes in the value of the currency affect the local currency value of dollar-denominated debt. Banks'  dollar-denominated liabilities relative to its local currency-denominated assets suddenly blow up leading to large-scale banking sector insolvency. Financial crises in turn can lead to currency crises because during a banking crisis (or default crisis), the central bank is pressured to expand the money supply to bail out weak banks (or the government). This ultimately reduces the value of the domestic currency. As the exchange rate is expected to depreciate, investors dump domestic currency assets in exchange for foreign currency, which leads to loss of foreign reserves and an eventual abandoning of the peg.

 

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