20 Exchange Rate Crises: How Pegs Work and How They Break
Notes to Instructor
Chapter Summary
This chapter develops a new central bank balance sheet model to examine exchange rate
crises. The chapter begins with an overview of what an exchange rate crisis is and the
costs associated with these crises. The following section develops a model of the central
bank balance sheet to highlight the importance of reserves in defending an exchange rate
peg. Subsequent sections study the roles of fiscal and monetary policies in exchange rate
crises. The chapter concludes with a discussion of the viability of exchange rate pegs.
Comments
This chapter provides an in-depth analysis of why exchange rate crises occur, unlike the
cursory analysis in the previous chapter. After presenting students with an overview of
crises and why they are costly, the chapter develops a detailed model of the role of
reserves, exchange rate expectations, and the trade–offs facing policy makers. This model
is a simplified version of more advanced models from the research literature, affording
students the opportunity to become familiar with relatively recent research on exchange
rate crises.
An outline of the chapter follows.
1. Facts About Exchange Rate Crises
i. Side Bar: The Political Costs of Crises
ii. Causes: Other Economic Crises
c. Summary
2. How Pegs Work: The Mechanics of a Fixed Exchange Rate
a. Preliminaries and Assumptions
b. The Central Bank Balance Sheet
c. Fixing, Floating, and the Role of Reserves
d. How Reserves Adjust to Maintain the Peg
e. Graphical Analysis of the Central Bank Balance Sheet
f. Defending the Peg I: Changes in the Level of Money Demand
i. A Shock to Home Output or the Foreign Interest Rate
ii. The Importance of the Backing Ratio
g. Application: Risk Premiums in Advanced and Emerging Markets
i. Summary
h. Application: The Argentine Convertibility Plan Before the Tequila Crisis
i. Money Demand Shocks, 1993–94
ii. To Be Continued
i. Defending the Peg II: Changes in the Composition of Money Supply
i. A Shock to Domestic Credit
ii. Why Does the Composition of the Money Supply Fluctuate?
j. Application: The Argentine Convertibility Plan After the Tequila Crisis
i. Banking Crisis, 1995
k. The Central Bank Balance Sheet and the Financial System
i. A More General Balance Sheet
ii. Sterilization Bonds
l. Summary
i. Two Types of Exchange Rate Crises
m. Side Bar: The Great Reserve Accumulation in Emerging Markets
i. Causes of the Reserve Accumulation
3. How Pegs Break I: Inconsistent Fiscal Policies
a. The Basic Problem: Fiscal Dominance
b. A Simple Model
i. The Myopic Case
4. How Pegs Break II: Contingent Monetary Policies
a. The Basic Problem: Contingent Commitment
b. A Simple Model
i. Small Recession, Peg Credible
ii. Large Recession, Peg Credible
iii. Large Recession, Peg Not Credible
iv. The Costs and Benefits of Pegging
c. Application: The Man Who Broke the Bank of England
d. Summary
5. Conclusions
a. Can We Prevent Crises?
Lecture Notes
This chapter considers the viability of fixed exchange rates over time. Before examining
the sources of crises, we first document the key characteristics of exchange rate crises in
practice. Then we develop a model of the central bank’s balance sheet to understand the
1 Facts About Exchange Rate Crises
In reality, the choice of fixed versus floating exchange rates not only depends on the costs
and benefits in the short run and the long run, as examined in the previous chapter, but
What Is an Exchange Rate Crisis?
An exchange rate crisis is a “big” depreciation: 10% to 15% for advanced economies and
20% to 25% for emerging markets and developing countries. Examples are shown in
Figure 20-1. It offers two important observations:
■ Exchange rate crises occur in advanced economies, as well as emerging markets
and developing countries.
■ The magnitude of a crisis is usually larger in emerging markets and developing
countries.
How Costly Are Exchange Rate Crises?
There are both political and economic costs associated with exchange rate crises.
Following a crisis, advanced economies tend to recover more quickly than emerging
markets and developing countries. We can observe the decline in economic growth
surrounding the exchange rate crises mentioned previously in Figure 20-2. The figure
also shows that emerging markets and developing countries experience not only a more
protracted decline in economic growth but also a more severe drop.
S I D E B A R
The Political Costs of Crises
Exchange rate crises are often associated with changes in government leadership (Figure
20-3). Why? We know that exchange rate crises are economically costly, especially in
developing countries and emerging markets. Examples of changes in political leadership
during a crisis and subsequent economic downturn include Indonesia’s Suharto (1997)
and Argentina’s Radical Party (2001–02).
In advanced economies, exchange rate crises affect public opinion. For example, in
Great Britain, the Conservative government decided to leave the ERM in September
Causes: Other Economic Crises Exchange rate crises are often associated with financial
crises. A banking crisis occurs when banks and other financial institutions face adverse
shocks, resulting in insolvency and bankruptcy. In the public sector, a default crisis
refers to the government’s unwillingness or inability to honor principal and interest
payments on its debt. Based on empirical evidence, we can summarize the relationship
between the three types of crises as follows:
■ The likelihood of a banking or default crisis increases significantly when a
country is experiencing an exchange rate crisis. Changes in the value of the
currency affect the local currency value of dollar-denominated debt.
Twin crises refer to two of the aforementioned crises happening at once. Triple crises
refer to a combination of exchange rate, banking, and default crises occurring
simultaneously.
Summary
This section documents the costs of exchange rate crises. We now move on to a model of
fixed exchange rates that addresses why these regimes are potentially unstable and why
crises occur.
2 How Pegs Work: The Mechanics of a Fixed Exchange Rate
We begin with the mechanics of a fixed exchange rate regime. We then use this model to
understand why exchange rate crises occur and discuss whether these crises can be
prevented.
Preliminaries and Assumptions
The assumptions are as follows:
■ The home currency (peso) is pegged to the U.S. dollar at a fixed rate of = 1 (1
peso per U.S. dollar).
■ The central bank controls the money supply, M, by buying and selling assets in
exchange for cash. The central bank trades only two assets: domestic bonds
denominated in the local currency (peso) and foreign assets denominated in the
foreign currency (dollars).
■ The central bank intervenes in the forex market to defend the exchange rate peg.
■ The foreign price level is stable at P* = 1. The home price level is sticky in the
short run at level P = 1. In the long run, if the exchange rate peg holds, the price
level will be fixed at P = 1, from purchasing power parity (PPP).
■ Real money demand, M/P, is determined by Y and i: M/P = L(i)Y. Real money
The Central Bank Balance Sheet
The central bank balance sheet is used to examine how the central bank manages assets,
such as domestic credit (B) and reserves (R), and its sole liability, money in circulation,
M.
■ Domestic credit reflects the central bank’s purchase of domestic bonds (domestic
■ Reserves are defined as foreign exchange reserves (foreign assets).
■ The central bank stands ready to exchange foreign currency at the exchange rate
peg, = 1.
■ The central bank buys and sells these reserves using money. When the central
bank buys foreign exchange reserves, the money supply increases. When the
Therefore, the central bank’s liabilities (M) are divided between domestic credit (B) and
reserves (R):
M = B + R
Fixing, Floating, and the Role of Reserves
The central bank holds reserves to defend the fixed exchange rate. The exchange rate
remains fixed if and only if the central bank holds reserves. If the country adopts a
How Reserves Adjust to Maintain the Peg
Assuming a fixed exchange rate regime, the central bank must hold some positive level
of reserves, R = M – B. From the money market equilibrium:
R = L(i)Y – B
Graphical Analysis of the Central Bank Balance Sheet
Figure 20-4 illustrates the central bank balance sheet in terms of domestic credit (vertical
axis) and the money supply (horizontal axis). This model serves as the foundation for
understanding why fixed exchange rate regimes might collapse.
■ Floating exchange rate regime:
● R = 0 and M = B
■ Fixed exchange rate regime:
■ A currency board system refers to the special case when M = R and B = 0.
It is worth mentioning to students that given a central bank balance sheet (with numerical
Defending the Peg I: Changes in the Level of Money Demand
Changes in money demand can arise from changes in home output, Y, or the foreign
A Shock to Home Output or the Foreign Interest Rate Changes in home output or the
foreign interest rate affect money demand, and therefore affect the money supply and the
reserves needed to defend the exchange rate peg. For now, we assume the central bank
(all peso amounts are in millions). Suppose the exogenous shock causes money demand
to fall by 10%.
■ Home output (Y):
● ↑ Y → ↑ L(i) → ↑ R → ↑ M
buy foreign currency/sell domestic currency
Point 3 in Figure 20-5
■ Foreign interest rate (i*):
● ↓ i* → ↑ L(i) → ↑ R → ↑ M
buy foreign currency/sell domestic currency
The Importance of the Backing Ratio The backing ratio is the percent of the money
supply held in reserves, 0 < R/M ≤ 1. Note that in the previous examples, R/M declines
when money demand decreases because the proportionate change in reserves is larger
than in the money supply. Because R < M, when R and M change by the same percent,
the backing ratio changes.
Currency Board Operation Recall that a currency board implies the money supply is
entirely backed by reserves, so M = R and B = 0. This implies a backing ratio of 100%. A
currency board is known as a hard peg because, for a given money demand shock, a
Why Does the Level of Money Demand Fluctuate? Thus far, we have seen how the
central bank must respond to money demand shocks. Earlier, we observed that output
tends to be more volatile in emerging markets and in developing countries, suggesting
APPLICATION
Risk Premiums in Advanced and Emerging Markets
According to the uncovered interest parity (UIP) condition, the foreign interest rate, i*,
and the domestic interest rate, i, should be equal under a fixed exchange rate regime. In
compensation investors require above the foreign interest rate.
The risk premium arises from
■ The currency premium: to compensate investors for uncertainty about the
exchange rate. This arises when the peg is not credible.
Changes in the risk premium are important because they affect the country’s ability to
defend the exchange rate peg. These changes are analogous to the money demand shocks
studied in this chapter. If the risk premium increases, money demand falls (increasing the
domestic interest rate), and forces the central bank to sell reserves to defend the peg.
Summary We observe that the Denmark‒Eurozone interest rate spread is much smaller
than the Argentina‒United States spread. This reflects a general observation that pegs in
emerging markets and developing countries differ from those in advanced countries.
Emerging markets and developing countries suffer from credibility problems, making it
more difficult to maintain the peg.
From panel (b) of Figure 20-6, we observe an additional challenge. Investors revise
their expectations based on events outside of the country. We observe that Argentina’s
interest rate increased in response to crises abroad. This is evidence of contagion in
global financial markets.
APPLICATION
The Argentine Convertibility Plan Before the Tequila Crisis
This application analyzes the operation of Argentina’s Convertibility Plan of 1991 to
2002. Under the plan, Argentina maintained a one-for-one peg against the dollar, with
Epeso/$ = 1. Figure 20-7 shows how the money supply and reserves fluctuated from 1993
to 1997, mapping these values onto the central bank balance sheet diagram. This section
discusses the beginning of the crisis; the aftermath is discussed in more detail in a later
application.
Money Demand Shocks, 1993–94
■ April 1993—point 1
M = 12 billion pesos, R = 8 billion pesos, B = 4 billion pesos
Backing ratio = 8/12 = 67%
■ November through December 1994—point 2
To Be Continued The increase in Argentina’s interest rate led to an economic recession
with severe consequences for banks. The central bank provided assistance to the banking
sector, ultimately leading to the collapse of the exchange rate peg.
Defending the Peg II: Changes in the Composition of Money Supply
In the previous section, the central bank’s response to money demand shocks was
assumed to be passive. That is, domestic credit remained unchanged. This section
A Shock to Domestic Credit The central bank can buy or sell domestic bonds,
potentially affecting the composition of the money supply. Figure 20-8 illustrates changes
in domestic credit.
■ For a given M, an increase in B implies R decreases and the backing ratio
Why Does the Composition of the Money Supply Fluctuate? The central bank may
buy or sell domestic credit for one of two reasons:
■ The central bank buys/sells government bonds to influence interest rates on
different bonds. There is little evidence of this in practice.
To study the role of central bank lending, we relax the assumption that the monetary base
(M0) is synonymous with the money supply (M1 or M2). We consider two cases of
banking crises.
■ Insolvency and bailouts:
● A private bank is insolvent when the value of its liabilities exceeds the value
in the market value of the assets.
● The government may prevent the bank’s failure through a bailout. The central
bank offers loans to the bank so that it can reinvest these funds to increase
■ Illiquidity and bank runs:
● Most private banks are illiquid: they lack sufficient cash to meet the demand
of depositors because their assets (loans) are less liquid than their liabilities
(deposits). If too many depositors try to withdraw cash or order payments at
once, the bank will be unable to honor these payments. This is known as a
bank run.
● The central bank can provide loans to help the bank meet depositors’ needs.
In practice, the distinction between insolvency versus illiquidity is difficult to identify.
Often, banking crises are characterized by both. If even a few large banks are insolvent,
APPLICATION
The Argentine Convertibility Plan After the Tequila Crisis
This application begins where the previous one ended: January and February of 1995
(point 3 in Figure 20-7).
Banking Crisis, 1995 The sharp increase in Argentina’s interest rate led to an economic
contraction and a banking crisis. The recession led to loan defaults (insolvency) and
eventually uncertainty, sparking bank runs (illiquidity).
■ January and February through May 1995 (point 3–point 4):
The net effect was little change in the money supply and a large reduction in reserves
Help from the IMF and Recovery Following the tequila crisis, the IMF loaned dollars
to Argentina, increasing reserves, and a fund was established to bail out failing banks.
■ May 1995 to November 1996 (point 4–point 5):
The banking crisis concluded and the central bank began replenishing reserves,
Postscript With a backing ratio of 100%, Argentina was in a position to adopt a currency
board system, potentially strengthening its exchange rate peg against the dollar, but did
not do so. The Convertibility Plan ended in 2001. The government ran out of time to
straighten out the economy: there was a recession, the government was deeper in debt,
the IMF and private creditors had reached their lending limits, and the government was
reduced to raiding the banks and the central bank for resources. We will postpone our
discussion of the gory details until the last chapter.
The Central Bank Balance Sheet and the Financial System
To conduct a more in-depth analysis of the central bank’s role in the financial system, we