Financial Fragility and the Exchange Rate Regime

NBER Working Paper No. 6469^*
Issued in March 1998
NBER Program(s): IFM

---- Abstract -----

We study financial fragility, exchange rate crises and monetary policy in an open economy model in which banks are maturity transformers as in Diamond-Dybvig. The banking system, the exchange rate regime, and central bank credit policy are seen as parts of a mechanism intended to maximize social welfare; if the mechanism fails, banking crises and speculative attacks become possible. We compare currency boards, fixed rate and flexible rates, with and without a lender of last resort. A currency board cannot implement a socially optimal allocation; in addition, under a currency board bank runs are possible. A fixed exchange rate system may implement the social optimum but is more prone to bank runs and exchange rate crises than a currency board. Larger capital inflows enhance welfare if the no-run equilibrium occurs, but may also render the economy more vulnerable to self-fulfilling runs. A flexible exchange rate system implements the social optimum and eliminates runs, provided the exchange rate and central bank lending policies of the central bank are appropriately designed.

^*Published: Chang, Roberto and Andres Velasco. "Financial Fragility And The Exchange Rate Regime," Journal of Economic Theory, 2000, v92(1,May), 1-34.

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