TOPIC 2.1 - Models of Currency Crises

Question 1

What is a Currency Crisis?

Answer 1

Sudden and unexpected collapse in the value of a nations currency. Faces heavy selling pressure and dumping of the currency.

Question 2

What is a Banking Crisis?

Answer 2

Banking system unable to perform its normal lending functions, and nations banks are threatened with insolvency.

Question 3

What is a Financial Crisis?

Answer 3

It is the general term for both Banking and Currency Crises.

Question 4

What is the First Generation Currency Crisis Model?

Answer 4

When a currency crisis is caused by expansionary fiscal policy. The main causal factor is government budget deficits.

Question 5

Explain the 8 step flow chart for the first generation model of currency crises.

Answer 5

1. Thai govt. prints money in order to pay and afford deficits
2. MS increases, IR decrease
3. People dump Baht due to low IR in Thailand
4. Supply of Baht increases, however with a fixed ER this creates excess Baht
5. The government buys the excess Baht which decreases foreign reserves
6. This reinstates MS & IR to their original rates
7. However a loop is created decreasing foreign reserves each time the govt prints money.
8. Speculative attack starts and currency crisis ensues.

Question 6

What is the Second Generation Model of Currency Crises?

Answer 6

It is focused on currency crises in the 1990s and the strategic game between governments and currency speculators.

Question 7

Second Model 5 step flow chart…

Answer 7

1. People expect the currency to devalue in the future
2. In response to this speculation the govt increases IR in order to stop capital outflow from people getting rid of the currency
3. However this response only makes investors doubt the strength of the currency even more
4. Investors believe the government will either abandon the fixed system or impose capital controls.
5. So they dump currency and the govt. is forces to abandon the fixed ER.

Question 8

What is the Third Generation Model of Currency Crises?

Answer 8

Caused by a moral hazard problem, explains the EA crisis in 1997. Economic fundamentals are sound but risky investment was a problem.

Question 9

Explain the 6 step flow chart for the Third Generation model.

Answer 9

1. FDI in EA
2. Moral hazard.
3. Risky Investments
4. Banks taking out dollar denominated loans which created a CA deficit.
5. Major disequilibria
6. Crisis started when investors withdrew which spread to the rest of the region

Question 10

Three major disequilibria arose from third generation model of currency crisis

Answer 10

1. Risky investment due to moral hazard
2. Mismatch between ST debt and LT investment
3. Mismatch between dollar foreign debt and domestic money investments