A More General Balance Sheet The items on the general central bank balance sheet
follow. We still assume that central bank capital equals zero.
■ Assets:
● Domestic liabilities:
* Domestic currency debt issued by the central bank—central bank
borrowing in domestic currency
● Money supply, M:
* Currency in circulation—currency in the hands of the public, outside of
with the central bank
Net foreign assets = foreign assets – foreign liabilities
Net domestic assets = domestic assets – domestic liabilities
Sterilization Bonds We can see from the general central bank balance sheet that
borrowing allows the central bank to accumulate foreign currency reserves while leaving
domestic credit and the money supply unaffected. Central bank borrowing is a way to
The central bank can maintain net domestic assets < 0 by issuing these sterilization
bonds (central bank-issued bonds) so that the backing ratio can exceed 100%. Figure 20-
The analysis from the simple model is redefined in terms of net foreign assets
(analogous to R) and net domestic assets (analogous to B). Because it is possible to have
net domestic assets <0, the central bank can maintain equilibrium along the fixed line that
is below the origin.
Summary
In the simple model of the central bank balance sheet, the money supply is backed by
foreign assets (reserves) and domestic assets (domestic credit). In response to money
demand shocks, the central bank buys or sells reserves to defend the peg. The central
bank can affect the composition of the money supply by issuing sterilization bonds.
Two Types of Exchange Rate Crises Figure 20-12 illustrates two potential sources of
exchange rate crises.
■ Panel (a):
● Domestic credit increases, draining reserves and forcing the balance sheet
■ Panel (b):
● A one-time expansion of the money supply eliminates reserves and forces the
S I D E B A R
The Great Reserve Accumulation in Emerging Markets
Sterilization bonds allow the central bank to accumulate reserves without changing the
money supply. We can use the general model to study the case of the People’s Bank of
China.
1995–2003:
Net domestic credit grows slowly, whereas economic expansion leads to a dramatic
increase in money demand. Therefore, corresponding expansion of the money supply was
Causes of the Reserve Accumulation
The situation in China is not unique. Figure 20-11 shows the accumulation of reserves
among selected Asian countries compared with the rest of the world. The sources of this
reserve accumulation are as follows:
■ Countries have the desire for a larger backing ratio to maintain a stronger
declines in M2.
● After the Asian crisis, countries accumulated reserves to build up sufficient
● Recall that banking crises and exchange rate crises depend on each other. If
3 How Pegs Break I: Inconsistent Fiscal Policies
This section presents a first–generation crisis model of how fiscal policies lead to an
exchange rate crisis.
The Basic Problem: Fiscal Dominance
Assumptions:
■ Y—output is fixed.
■ P—the price level is flexible and determined based on PPP.
■ E—the exchange rate is fixed.
■ DEF—the government runs a budget deficit because taxes are insufficient to
finance spending.
● Fiscal dominance means the government can require the central bank to
finance the deficit through buying government bonds. The government,
● The growth in domestic credit and government deficit is assumed to be
A Simple Model
We’ve assumed that the deficit grows by some fixed percentage and that this deficit is
unexpected from year to year. When the country is forced to float, the money supply, and
therefore prices, grow at rate
µ
. The exchange rate depreciates at rate
µ
.
The Myopic Case In this case, investors are myopic, meaning they do not adjust their
expectations despite the deficit and expanding domestic credit. Figure 20-13 illustrates
the behavior of key variables over time in the model.
■ Time 1:
■ Time 1 through time 4:
● B grows at rate
µ
= 10%; R declines by 10% each period.
■ Time 4:
● R = 0, M = B.
● The country is forced to float.
■ Time 4 onward:
● M grows at rate
µ
with the expansion of B.
The Forward-Looking Case In practice, investors will observe the deficit and quickly
realize that the exchange rate peg is not sustainable. They will be forward-looking and
adjust their exchange rate expectations, selling off their peso–denominated assets in
anticipation of the depreciation. In the following model, we assume they have perfect
foresight.
■ Time 1:
● M > B, R > 0.
● B grows at rate
µ
. The central bank buys government bonds to finance the
fiscal deficit.
● M = P = E = 1.
■ Time 1 through time 2:
● Speculative attack. Investors anticipate the depreciation in the peso and
immediately sell all their holdings of the country’s currency.
APPLICATION
The Peruvian Crisis of 1986
This section applies the first-generation model shown previously to the case of Peru in
1986.
economic downturn meant the government relied on the central bank to finance
expanding fiscal deficits. Domestic credit roughly doubled each year between 1982 and
1984 and the Peruvian sol depreciated.
Immediately after his 1985 election, President Alan Garcia Perez implemented a fixed
exchange rate regime and worked toward solving fiscal problems:
■ The deficit fell from 2% to 3% of GDP to nearly 0% in early 1986, only to grow
again, peaking at 7% to 8% of GDP in late 1986 and 1987.
■ The data match the predictions of the forward-looking model:
● Domestic credit increased, reserves declined.
Expectations and the Critical Level of Reserves Recall that the timing of the
speculative attack depends on when investors lose confidence in the exchange rate peg. In
the speculative attack/forward-looking model, the investors will watch the change in
reserves to determine whether the peg is sustainable.
Assumptions:
■ A one percentage point increase in the interest rate causes a
ϕ
% decrease in real
money balances.
■ At the critical point of speculative attack, ∆i =
µ
. Therefore, the money supply
Therefore, the critical level of reserves needed to defend the peg is a function of the
sensitivity of money demand to changes in the interest rate,
ϕ
, and the expected future
growth rate of domestic credit,
µ
.
It is important to note that it is expectations that matter, not the actual growth rate of
Summary
According to the first-generation crisis model, the existence of inconsistent fiscal policies
causes the collapse of the exchange rate peg. In the forward-looking model, it is not the
actual fiscal policies that matter, but rather investors’ expectations of fiscal policy.
4 How Pegs Break II: Contingent Monetary Policies
Some exchange rate crises, such as the 1992 ERM crisis, cannot be explained by the
The Basic Problem: Contingent Commitment
The model is premised on the fact that exchange rate pegs involve a contingent
commitment by policy makers. Investors understand that there are conditions under
which a government will abandon an exchange rate peg. The model is based on the idea
of multiple equilibria. Which equilibrium the economy ends up at depends on investors’
self–fulfilling expectations.
Consider the case of Britain and Germany in 1992. German reunification led to an
expansion in government spending that was offset by an increase in interest rates. Britain
A Simple Model
■ The cost of maintaining the peg is assumed to be the deviation in output caused
by remaining on the fixed exchange rate regime. This cost is equal to the output
■ The benefit of the peg is assumed to be some constant, b > 0, meant to capture
efficiency gains (discussed in the previous chapter).
Small Recession, Peg Credible
■ Figure 20-16, panel (a): the economy experiences a small recession.
Large Recession, Peg Credible
■ Figure 20-16, panel (b): the economy experiences a large recession and the peg is
credible.
■ If the market believes that the peg is credible, the output gap (cost) increases as
the size of the adverse shock increases.
■ In order to keep the exchange rate pegged, the central bank must reduce the
Large Recession, Peg Not Credible
■ Figure 20-16, panel (c): the economy experiences a large recession and the peg is
not credible.
■ The central bank must contract the money supply by a larger amount, i1 > i*,
because investors require a currency premium. This implies an even larger decline
in output.
The Costs and Benefits of Pegging Figure 20-17 summarizes the cost‒benefit analysis
conducted previously. The costs and benefits of pegging are plotted as a function of the
costs of pegging when the peg is credible.
■ The benefits of the peg are fixed and given with b > 0.
■ c(Efloat): The cost of maintaining a noncredible peg is higher than maintaining a
There are three zones shown in the graph, one of which allows for multiple equilibria:
■ Zone I: Unique equilibrium—peg, b > c(Efloat) > c( )
■ Zone II: Two equilibria—peg or depreciate, c(Efloat) > b > c( )
● Peg is not credible: c(Efloat) > b.
● When the economy is in Zone II, the equilibrium outcome hinges on investors’
expectations. This is known as a self–confirming equilibrium.
APPLICATION
The Man Who Broke the Bank of England
In practice, the instability created by the existence of multiple equilibria and self–
fulfilling expectations reaches beyond the output losses examined in the model.
■ The previous model assumed the switch from a peg to float happens gradually.
● In reality, this happens quickly because the currency premium expands
rapidly, forcing the government to abandon the peg long before reserves are
depleted.
● A 10% devaluation over a year is large. But if the 10% devaluation is
■ The model presumes that an individual trader does not have the ability to
influence the forex market.
● In practice, large-volume traders can move market expectations. If a few of
● During the ERM crisis, the Quantum Fund, owned by George Soros,
● The British government did not implement the sharp interest rate hikes
Sweden used earlier to defend its peg. In the middle of an economic recession,
Britain abandoned the peg, after spending £4 billion trying to defend it.
Summary
The exchange rate peg involves a contingent commitment by the government so that
investors’ expectations about the exchange rate influence the government’s ability to
defend the peg. In this way, investors’ expectations have the potential to influence real
economic outcomes. Whether or not the currency will suffer from a speculative attack
depends on investors’ self–fulfilling expectations.
5 Conclusions
This chapter reviews the consequences and sources of exchange rate crises. We begin
with a model of the central bank balance sheet to understand the mechanics of an
Can We Prevent Crises?
If a speculative attack can be caused by a change in expectations, then is there
any way to defend exchange rate pegs?
■ The case for capital controls. Capital controls restrict the flow of foreign currency
trading. These controls are hard to implement in practice, especially when
■ The case against intermediate regimes. Intermediate regimes are very risky in that
investors are less likely to view the peg as credible because it lacks a firm
contingent commitment from the government. In the context of the trilemma,
■ The case for floating. Without an exchange rate peg, countries need not worry
about exchange rate crises. However, as we examined in this chapter and in the
■ The case for hard pegs. If a country wants to maintain a peg, then hard pegs or a
■ The case for improving the institutions of macroeconomic policy and financial
■ The case for an international lender of last resort. If countries have the ability to
borrow foreign reserves, then they would be in a better position to defend the
■ The case for self–insurance. If none of the previous options appeal or are possible,
TEACHING TIPS
Teaching Tip 1: On August 17, 1998, Russia defaulted on its debt. The default has been
analyzed by Abbigail J. Chiodo and Michael T. Owyang (Federal Reserve Bank of St.
Louis, available at
class read this paper and discuss how the Russian default fits into the framework outlined
in this chapter. Specifically, does this default seem to be a result of inconsistent fiscal
policies or contingent monetary policies?
Teaching Tip 2: Shang-Jin Wei and Yi Wu argue that corruption can be a major factor
that precipitates a currency crisis (“Negative Alchemy? Corruption, Composition of
Capital Flows, and Currency Crises,” NBER Working Paper 8187, March 2001. If your
and Wu develop a model in which crony capitalism and self-fulfilling expectations are
complementary contributors to currency crises, rather than rival explanations. Their
conclusion: crony capitalism can be a leading indicator of a crisis. They use three
measures of corruption:
1. The World Economic Forum’s Global Competitiveness Report
2. The World Bank’s World Economic Development Report (1997)
3. A data set compiled by PricewaterhouseCoopers
Data for selected countries from the 2010 edition of the World Economic Forum’s
report, as well as the 2005 World Economic Development Report, are included in the
Excel workbook for this chapter.
IN–CLASS PROBLEMS
1. Consider how fixed exchange rate regimes differ in advanced economies versus
emerging markets/developing countries.
a. How do exchange rate crises differ across these groups?
Answer: Exchange rate crises are associated with smaller depreciations in
b. Among which group are the economic costs higher? Cite evidence to support your
answer.
Answer: The economic costs are more severe in emerging markets and
c. A depreciation leads to an expansion in export demand. Given your answer to (b),
why does the other group of countries suffer political costs?
Answer: Advanced economies suffer political costs even though economic costs
d. Based on the analysis in the previous chapter, which group of countries is more
likely to adopt a fixed exchange rate regime?