FINANCIAL CRISES Flashcards
How is an overvalued exchange rate an issue?
This is a crisis caused by a bad financial decision.
Consider the market for pounds. Suppose the Bank of England wants to increase the value of the pound and starts selling foreign exchange reserves to buy pounds.
This shifted the demand curve for pounds rightwards.
This can lead to an overvalued exchange rate whereby uk exports become too expensive and uncompetitive.
This can cause a growing current account deficit and falling official reserves.
This can be countered by a forced devaluation of the pound which is a painful adjustment, as imports will shrink suddenly.
Explain a crisis caused by hyperinflation
This is a crisis caused by bad financial decisions.
Suppose a country has a growing fiscal deficit (gov spending>tax revenue)
The central bank may start printing money to finance the deficit.
This injects a lot of liquidity into the economy and may lead to surging inflation.
Ie if the BoE start printing pounds, the supply of pounds will increase.
This may cause a large depreciation of the pound as a side effect.
Such crises have occurred in Venezuela, Argentina and Zimbabwe
What are preemptions to crises caused by bad financial decisions?
Avoid an overvalued exchange rate
Have fiscal and monetary discipline
Explain the crisis caused by contagion
This is a crisis caused by external factors.
Consider the market for pounds. Some of the supply of pounds comes from capital inflows.
Contagion occurs when there is a sudden stop in capital inflows due to issues in a neighbouring country that affect the confidence in the uk’s financial sector. This causes the demand for pounds to shift left and the pound to depreciate.
What are preemptions of contagion?
Avoid reliance on foreign inflows
Ie Avoid running a persistent current account deficit and place restrictions on capital inflows
