Chapter 12
International Financial Crises
◼ Outline
Introduction: The Challenge to Financial Integration
Definition of Financial Crisis
Sources of International Financial Crises
Crises Caused by Macroeconomic Imbalances
Crises Caused by Volatile Capital Flows
Case Study: The Mexican Peso Crisis of 1994 and 1995
Domestic Issues in Crisis Avoidance
Moral Hazard and Financial Sector Regulation
Domestic Policies for Crisis Management
Reform of the International Financial Architecture
A Lender of Last Resort
Conditionality
Reform Urgency
Case Study: The Global Crisis of 2007
◼ What Students Should Know after Reading Chapter 12
The primary goal is for students to understand the characteristics and economic results of an exchange rate
crisis and a banking crisis. Although financial crises have many characteristics, the chapter shows that they
usually refer to either a banking crisis (2007) or a currency crisis (Mexico’s case study). The Asian crisis
case study shows that it began as a currency crisis but quickly developed into a banking crisis as well. The
crisis might be caused by macroeconomic imbalances or it could be caused by volatile flows of financial
68 Gerber • International Economics, Sixth Edition
The chapter includes several case studies which build on each other, beginning with the “Tequila Crisis”
of the Mexican peso in 1994–1995, the Asian crisis of 1997–1998, and culminating in the global financial
crisis of 2007–2009. The later crisis is presented as having resulted from three microeconomic factors and
one macroeconomic factor. The micro-factors are global integration of financial markets, financial
◼ Suggested Writing Assignment
1. One of the most important concepts discussed in the text is the moral hazard problem. Even though
this problem cannot be eliminated completely, it can be reduced through various actions such as the
Basel Agreements.
Students find moral hazard very interesting and intellectually stimulating. Students may be asked to
submit a summary of these agreements (Basel I and II) using the Web site of the Bank of International
Settlements. Specifically, students may be asked to briefly explain the moral hazard concept and
summarize the three pillars of the Basel Agreements, which are:
2. An alternative writing assignment could involve the contagion effects of a financial crisis. Multiple
opinions on this topic exist. Some argue that there may not be any contagion effects of a financial
crisis. On the other hand, as is shown in the text, the moral hazard problem is very real and has a
3. After researching current proposals for reform, students could write up or present to the class one
proposed reform and explain its potential advantages and disadvantages. A broader question could
be focused on whether the IMF is necessary today, and if so, what should its functions include?
Chapter 12 International Financial Crises 69
◼ Answers to End-of–Chapter Questions
1. What is an international financial crisis, and what are the two main causes?
Answer: An international financial crisis is a financial disintermediation characterized by a
2. In the text, the point is made that the expectation of a crisis from volatile capital flows is sometimes a
self-fulfilling crisis. How can a crisis develop as the self-fulfillment of the expectation of a crisis?
Answer: At times, investors and portfolio managers look to each other for information about the
3. What are three things countries can do to minimize the probability of being hit by a severe
international financial crisis?
Answer: Governments can minimize the likelihood of, and the damage caused by, financial crises
4. Why are crises associated with severe recessions? Specifically, what happens during an international
financial crisis to create a recession in the affected country or countries?
Answer: There are at least two reasons why crises are associated with recessions. First, in addition
to the possible trigger(s) of the crisis, several economic problems and weaknesses often
5. What type of exchange rate is associated with a higher probability of experiencing a crisis? Why?
Answer: The type of exchange rate associated with a higher probability of experiencing a crisis
is a pegged exchange rate system called the crawling peg. With a crawling peg, the
6. In a crisis not caused by macroeconomic imbalances, economists are uncertain whether a country
should try to guard against recession or try to defend its currency. Why are these mutually exclusive,
and what are the pros and cons of each alternative?
Answer: Economists are uncertain whether a country should try to guard against recession or try to
7. Explain the moral hazard problems inherent in responding to a crisis.
Answer: A moral hazard problem exists when one party involved in a transaction has both the
incentive and the ability to shift costs onto the other party.
8. Some people argue that the U.S. loans to Mexico in 1995 led to the East Asian crisis. Explain the
logic of this argument.
Answer: The main argument is that the United States created a moral hazard problem by bailing out
9. Some countries impose capital controls as a means of preventing a crisis. Evaluate the pros and cons
of this policy.
Answer: The issue of capital controls (usually accomplished by limiting the quantity of capital
transactions, taxing transactions, requiring advance notices and waiting periods, etc.) is a
10. How has the role of the IMF come under scrutiny in the recent discussion of reforms in the
international financial architecture?
Answer: As shown in Chapter 2 of the textbook, one of the roles of the IMF is to act as a lender of
last resort. There are two questions that are being raised on the role of the IMF as a lender
72 Gerber • International Economics, Sixth Edition