Macroeconomics - ER crises Flashcards
what is the first generation Krugman model
what does it explain
it explains the onset of a currency crisis as due to poor macroeconomic performance and inconsistent MP
- it represents the basic relationship between core macroeconomic variables and the exchange rate
what increases domestic credit
- printing more money
- financing domestic public debt
what happens when
DC growth > MD growth
when E is flexible
- the economy spends more than it earns
- increases current account deficit - can be counteracted with a surplus of capital account - but if not then ER has to depreciate to adjust for the imbalance
what happens when
DC growth > MD growth
when E is fixed
- current account deficit
- monetary authority needs to defend parity by buying excess supply of DC using foreign exchange reserves = to prevent excess inflation
what does a constant DC expansion imply
why does this worry investors
constant depletion of foreign reserves
investors lose confidence - they need the reserves to cash in their investments - and dont want devaluation otherwise they will lose money in their foreign currecny
- they want to sell their investments before reserves are depleted - which further depletes reserves
how does flexible ER not deplete reserves
- e adjusts
- e devalues to maintain PPP = higher value of e
- higher IR to maintain UIP
- higher IR reduces real MD
- nominal m doesnt have to change
- avoiding the need to depelete reserves
why does fixed ER have to deplete reserves
- e is fixed - so is p and IR are given
- m is fixed
- r must be reduced so that m falls to keep balance between MS and MD
- or unemployment can be increased
when is the time of collapse sooner from the model
- the larger the initial share of DC (larger public debt)
- the lower initial share of foreign reserves
- the higher the rate of DC expansion
- the higher the semi interest elsaticity of demand for money
why do foreign investors exit
- when reserves fall below a threshold value they exit - still need reserves to cash out their investments
- dont want devaluation - because will lose money in their currency
- want to exit before devaluation
- further depletes reserves
what are limitations of the 1st gen model
doesnt take capital account into account
what is the 2nd generation currency crisis model
- crisis possibility even when the economies monetary position is not weak
- currency crisis induced by shift in market sentiment
what can lead to 2nd gen crisis
- herd behaviour
- agents copy other agents and dont use information that reflects the state of the economy
- can cause actual capital reversal
- leads to actual currency crisis
what do level of reserves indicate
2nd gen
ability to defend the peg
high reserves = able to defend
mid reserves = fundamentals not strong or weak
low reserves = vulnerable to attack by an agent - even if fundamentals arent that bad
in what 2 ways can agents cause a crisis
2nd gen
- imperfect info
- agents misjudge the level of reserves - asymmetric info
- agents abandon own info and join the herd
what is herd behaviour
agents start copying other 2 agents
- sequential
- believe first 2 agents actions are better than own info - so copies
- increases the probability that the best option i* is not chosen
- a few key agents induce a change in sentiment (acting on private info (could be wrong)) everyone else follows
