Currency Crises

Key terms:

• appreciation: a rise in value of one currency in terms of other currencies
• depreciation: a fall in value of one currency in terms of other currencies
• currency speculation: investors make decisions about where to invest based on the expectation that exchange rates will change substantially in the future

How people estimate currency:

• differences in inflation rates: It is generally expected that the currency of a country with high inflation will depreciate against the currency of a country with low inflation because in the long run, exchange rates tend to balance out and reach the power parity.
• deviations from purchasing power parity: Due to the concept of balancing an equal cost of exchange between two countries (the power parity), if a country’s purchasing power looks cheap, the currency will usually appreciate; if a country’s purchasing power looks expensive, the currency will usually depreciate.
• large account imbalances: If a country is running a large account deficit, it is likely to eliminate the deficit through the depreciation of its currency so the country’s goods would look cheaper. Investors therefore expect that countries with account deficits to depreciate, and those with account surpluses to appreciate.
• stress on exchange rate: It is likely that if a country incurs high interest rates during a recession, for example, that the withdrawal of investment due to the high interest rates would cause a depreciation in the country’s currency.

Floating vs. Fixed exchange rate:

• Floating exchange rate: The government lets the exchange rate go wherever the market takes it.
• Fixed exchange rate: The government keeps the exchange rate against another currency or near a particular target.
• Problem with a fixed exchange rate: Depreciation and appreciation make it harder to achieve a fixed rate. Because the exchange rate is not flexible, a fixed exchange rate regime is more likely to collapse.

So, what is a currency crisis? A currency crisis or a speculative attack occurs when it is expected that a fixed exchange rate will be abandoned and depreciation in currency will lead investors to sell large quantities of the currency.

2 possible reasons for a currency crisis:
a. loss of reserves

Investors can predict that over time that it is probable that a country will run out of its reserves. Therefore, even if the exchange rate is fixed, investors will expect depreciation and sell their currency.

b. loss of public patience

Many times, the public looses patience with the government. An example of this would be when, for example, the government implements tight monetary policy which in turn generates high interest rates, a depressed economy and high unemployment. In this example, the public expects that their currency will depreciate, and because people withdraw their currency, interest rates increase more. Due to higher interest rates, political protest caused the government to abandon their exchange rate.

Is a speculative attack self-fulfilling?
Many economists argue that speculative attacks are self-fulfilling. If a government wants to maintain a fixed rate, but investors believe that the fixed exchange rate will be abandoned, the investors’ expectation that the government will abandon its fixed exchange rate will result in the selling of their currency, as well as higher interest rates and capital outflows. As a result, some economists argue that such an expectation will force a county to abandon its fixed rate, thus generating a speculative attack.

Partially self-fulfilling speculative attacks:
Some economists agree that there are countries with economies strong enough to resist a speculative attack, but that are also weak enough to be forced to adopt a floating exchange rate because of a speculative attack through a self-fulfilling prophecy.

The Contagion Effect:
The theory of partially self-fulfilling prophecies has often been used to explain why currency crisis occur in waves, with a currency crisis in one country followed by a currency crisis in another country. The termed contagion is used to describe this trend, predicting that the loss of a fixed exchange rate in one country will lead investors to worry about the stability of the fixed exchange rate in another regime.

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Home Page | About Currency Crises Thailand's Currency Crisis | Thailand's Currency Crisis: Effects | Thailand's Currency Crisis: Solutions Argentina's Currency Crisis | Argentina's Currency Crisis: Effects | Argentina's Currency Crisis: Solutions Currency Crises: Works Cited

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