Currency Crises Flashcards
The two main reasons interest rates across countries differ assuming open capital mobility
country and currency (exchange rate) risk
country risk
the risk of default on debt interest payments due to political instability
currency risk
the risk of exchange rate fluctuations when investing in foreign assets
How does a currency risk premium work if we expect the pound to depreciate?
If we expect the pound to depreciate against the dollar, then the British interest rate needs to be higher to compensate for potential losses in converting between dollars and pounds and back.
How is the currency risk premium found?
Using uncovered interest rate parity (UIP) which states that the difference in the interest rates is given by the expected value of depreciation in percentage terms
What are two other factors affecting investment decisions aside from country and currency risk?
risk aversion –We assume investors to be risk neutral, but that is not really the case in reality
country bias –investors are more likely to invest in their own country than other ones because they may feel they “don’t know enough about the foreign country”
How do changes in the risk premia affect national income?
an increase in the risk premia causes domestic interest rates to rise, causing investment spending and national income to fall.
What is an effective alternative to devaluation?
Fiscal and monetary expansion, The government can impose fiscal expansion and the CB can expand the money supply to maintain the pegged rate
What is a downside of capital outflow surges?
insolvency risk for firms and banks holding foreign currency debt
Why not fix and impose capital controls?
- Misaligned exchange rates with capital controls can also cause global imbalances, leading to political tensions
- From the late 1990s onwards, China has run persistent large trade surpluses with the US, thus Trump has labeled China as the “world champion” in currency manipulation
