Economics Web Chapter Emerging Market Countries Can Also Devote More

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Web Chapter

Financial Crises in Emerging Market Economies

◼ Chapter Outline, Overview, and Teaching Tips

Chapter Outline

Dynamics of Financial Crises in Emerging Market Economies

Stage One: Initiation of Financial Crisis

Application: Crisis in South Korea, 1997–1998

Financial Liberalization/Globalization Mismanaged

Perversion of the Financial Liberalization/Globalization Process: Chaebols and the South Korean

Crisis

Application: The Argentine Financial Crisis, 2001–2002

Severe Fiscal Imbalances

Adverse Selection and Moral Hazard Problems Worsen

Policy and Practice: Preventing Emerging Market Financial Crises

Beef Up Prudential Regulation and Supervision of Banks

Overview and Teaching Tips

This Web chapter is for instructors who want to have a more international orientation of their courses. It

extends the analysis in Chapter 15 on financial crises to economies that are just entering the world

marketplace. The analysis is parallel to that in Chapter 15, with Figure W.1, which is similar to Figure

15.1, outlining the dynamics of financial crises in emerging market economies. Then the chapter takes

262 Mishkin • Macroeconomics: Policy and Practice, Second Edition

students through two detailed applications, South Korea in 1997–1998 and Argentina in 2001–2002, to

illustrate how useful the analysis in the chapter is.

I have found that my students particularly enjoy the discussion of the crazy government policies that

promote financial crises in emerging market countries, and I spend a lot of time on this in the case on

◼ Answers to End-of-Chapter Questions

1. Mismanagement of financial liberalization or financial globalization that leads to excessive risk

2. If financial liberalization and globalization are not done properly, financial institutions have

tremendous incentives to take on risk and a lending boom ensues. When the lending boom crashes, it

3. Severe fiscal imbalances can result in governments encouraging financial institutions to buy the

government debt. Then when the government is unable to repay the debt, financial institutions suffer

4. A rise in interest rates as a result of rising interest rates abroad increases moral hazard and adverse

selection problems, while a collapse in the stock market decreases the net worth of firms, which also

5. Deterioration in bank balance sheets makes it difficult for central banks to raise interest rates to

defend the currency because if they do so it will make banks worse off. Once speculators recognize

Web Chapter Financial Crises in Emerging Market Economies 263

6. With debt contracts denominated in foreign currency, the debt burden of domestic firms increases

when there is an unanticipated decline in the value of the domestic currency. Because assets are

7. The financial crises increased financial frictions sharply, which caused the aggregate demand curve to

8. They can put in place regulations to increase the amount of bank capital so banks have a greater

cushion if they suffer loan losses and also have greater incentives to pursue safer investments because

9. Emerging market countries can adopt regulations or impose taxes that restrict businesses from

borrowing in foreign currencies. Prudential regulation and supervision of banks can limit them from

10. Emerging market countries might want to implement financial liberalization and globalization

gradually because this would give them time to set up better prudential regulation and supervision to

limit risk taking by financial institutions.

◼ Data Sources, Related Articles, and Discussion Questions

A. For Information About Application: Crisis in South Korea: 199 –1998

Data Source

Federal Reserve Bank of St. Louis database (FRED):

balance improves sharply as the won depreciates, thereby contributing to South Korea recovery from the

crisis.

264 Mishkin • Macroeconomics: Policy and Practice, Second Edition

Hahm, Joon Ho and Frederic S. Mishkin, “Causes of the Korean Financial Crisis: Lesson for Policy”:

Discussion Question

As shown in the textbook and the data sources, South Korea benefited partially from the depreciation of its

currency, which resulted in an increase in their net exports in the aftermath of the financial crisis.

Comment on the pros and cons of a sharp depreciation of the local currency.

Answer: A sharp depreciation of the local currency will lower the price of domestic production and

thereby increase exports. At the same time it increases the price of imports, resulting in an improvement of

B. For Information About Application: The Argentine Financial Crisis: 2001–

2002

Data Source

The Guardian, “Timeline: Argentina’s Economic Crisis”:

Federal Reserve Bank of San Francisco, “Learning from Argentina’s Crisis”:

Discussion Questions

How would you avoid the problem of provinces controlling a large percentage of public spending but the

federal government being in charge of collecting revenue in Argentina? Why do you think this would be

an important issue to solve?

Answer: Solving this problem would be very important for Argentina because it is a constant source of

trouble for every government. As stated in the textbook, this structure makes it very difficult for the

Web Chapter Financial Crises in Emerging Market Economies 265

C. For Information About Policy and Practice: Preventing Emerging Market

Financial Crises

Data Source

Giordano, Claire, “Prudential Regulation and Supervision Instruments and Aims: a General Framework”:

Mishkin, Frederic S., “Prudential Supervision: Why Is It Important and What are the Issues?”:

Discussion Question

As a potential solution to currency mismatch and other problems experienced by emerging markets

economies facing financial crises, some authors have proposed the adoption of a foreign currency, like the

U.S. dollar, a concept known as “dollarization”. Based on this paper,

Answer: Dollarizing an economy has potential benefits, and a few countries (as explained in the paper)

have chosen to follow this recommendation and harvested some interesting results (e.g., no currency