Final: Financial Crises

Question 1

Purchasing Power Parity (PPP)

Answer 1

Price arbitrage
Exchange rate determined by price level
Currency appreciations/depreciations are driven by inflation differentials between countries

Question 2

Absolute PPP

Answer 2

derived from Law of one Price (LOOP)
In the absence of trade frictions and under free competition identical goods sold in different locations must sell for the same price, when expressed in the same currency.

Question 3

Relative PPP

Answer 3

∆𝑠= 𝜋_𝑡−〖𝜋∗〗_𝑡
Exchange rate driven by inflation differentials

∆𝑠= 5% - 2%
∆𝑠= 3% (domestic currency depreciates by 3%)

Question 4

Relative PPP provides an intuitive framework to analyze the effects of

Answer 4

domestic inflation on exchange rates.

Question 5

Inflation reduces the

Answer 5

the purchasing power of money.

Since an exchange rate is simply the ratio of the “prices” of two monies, it follows that inflation will also reduce the value of a fiat money relative other fiat monies.

Question 6

Currency Crises

Answer 6

A large and rapid depreciation of a currency.

These can be characterized according to what forces bring the crisis about
First Generation
Second Generation
Third Generation
Political Risk

Question 7

Who recovers quicker form currency crises?

Answer 7

Advanced economies tend to recover from the effects of currency crises faster

Question 8

Costs of recovery from currency crisis

Answer 8

Government reputation may be damaged.

More specifically, the reputation and trust placed in a central bank might be damaged. The public may no longer trust that the central bank will honor fixed exchange rates.

Real economic costs. Output is lower, and the crisis may also spread into the banking sector.

Currency crises can lead to debt/default crises as well.

Question 9

How do currency crises happen for fixed exchange rates?

Answer 9

A speculative attack on the peg: Money-holders and arbitrageurs don’t think the central bank has ample reserves to defend the peg. They begin to sell domestic currency and exchange it for dollars, hoping to come out on top when the fixed exchange rate fails, and the domestic currency depreciates.

Question 10

How do currency crises happen for floating exchange rates?

Answer 10

Rapid devaluation of a currency, usually tied to high inflation or hyperinflation

Question 11

Timing of Currency Crises (Fixed)

Answer 11

Phase 1:
Central Bank honors a fixed exchange rate.

Phase 2:
Uncertainty regarding either the ability or willingness of the central bank to defend the fixed exchange rate.

Phase 3: Crisis
The fixed exchange rate is attacked, and reserves are depleted at the central bank.

Phase 4: Float
Once reserves run out, the peg fails, and the currency must float. This is typically accompanied by rapid depreciation of the home currency and domestic inflation.