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International Business. Crises and Exchange rate - Essay Example

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Exchange rate adjustments often result from crises. The monetary agency's powers and scope are important determinates of the currency board's ability to weather crises. Consider five types of crises and how a currency board system handles them. First, a government's policies can create an economic crisis, particularly if it is running excessively expansionary policies that generate inflationary pressures in excess of those in the reserve currency country…
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International Business. Crises and Exchange rate
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Download file to see previous pages Even if there is no monetary agency, a government can create an inflation/debt crisis by excessive spending financed by domestic and international borrowing. Mutatis mutandis, the same considerations apply to a central bank that has the same degree of strictness as the currency board. (Betts, C. and Devereux, M, 2000)
Second, world securities markets might crash as, for example, in October 1987 or in the October 1989 mini-crash. Many countries' central banks expanded their stocks of high-powered money to provide liquidity to markets as investors fled from equities and corporate bonds and to high-quality assets such as U.S. T-bills and T-bonds. A currency board is ill-equipped to handle this type of crisis. At a time when it need to increase liquidity by expanding the domestic supply of money, a currency board is likely to have domestic currency presented for conversion to the reserve currency, as international investors who fled to U.S. government securities did in the 1987 and 1989 crises. This flight reduces the stock of domestic currency as well as that part of the country's international reserves that the currency board holds. In turn, domestic banks are less willing to provide liquid assets, and depositors are more interested in holding the reserve currency directly (or liabilities of the reserve-currency country). (Jan Winiecki, 2002).
A domestic monetary agency parallel to the currency board might expand liquidity, as measured by the domestic money stock, through open market operations. There may well be a flight from domestic assets to reserve currency assets. The monetary agency can preserve the exchange rate by selling reserve currency obtained from selling its own liquid holdings denominated in the reserve currency or by borrowing reserve-currency assets, either commercially from foreign banks or from the reserve-currency central bank. A small country with only a brief track record and low international holdings will likely find it difficult to preserve the exchange rate parity; a monetary agency that has the holdings and power to preserve the parity is likely also to have the power to undercut currency board discipline over monetary and fiscal policy.
Disturbances to Equilibrium Real Exchange Rates
Third, the currency to which the board pegs may come under pressure from output market disturbances in the reserve-currency country. An example is the pressure on the European Exchange Rate Mechanism (ERM) after German reunification to either revalue the German mark or devalue the other ERM currencies relative to the German mark.
The interpretation of the September 1992 and July-August 1993 crises in the European Monetary System is that they arose in substantial part from the reunification of Germany. German aggregate demand rose substantially more than German aggregate supply. This increase caused upward pressure on German interest rates (with some observers arguing that the increase in interest rates was exacerbated by German reluctance to use taxes rather than bond issuance to finance the ...Download file to see next pagesRead More
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