Week 7

Question 1

Of what does the policy trilemma consist?

Answer 1

Fixed exchange rate
Monetary policy independence
International capital mobility

Question 2

How to prevent financial crisis?

Answer 2

1. Better bank regulation, supervision and risk management
2. Captial controls;
   To prevent excessive capital inflows/overborrowing/overlending. To discourage short-term borrowing and to limit contagion to other countries

Question 3

What is the free rider problem?

Answer 3

A situation where those who benefit from a common resource do not pay for or, which results in an underprovision of this good or service

Question 4

What is debt restructuring?

Answer 4

Changes in terms of conditions of existing debt

• rescheduling: pushing repayments schedule to the future
• reduction: lowering the amount of outstanding debt

Downside = free rider problem

Question 5

What is moral hazard

Answer 5

Moral hazard is a situation in which one party gets involved in a risky activity knowing that it is protected against the risk and the other party will incur the cost

Question 6

What is a rescue package?

Answer 6

Additional low-interest loans to:

• compensate for the lack of private lending
• restore investor confidence by replenishing foreign reserves and signal international support
• limit contagion to other countries
• enforce policy changes

Question 7

Reasons for contagion (2 more)

Answer 7

Because of overreaction by foreign lenders and selffulfilling expectations
Or wake-up call

Question 8

What is contagion?

Answer 8

Spread of a currency crisis to other countries because of economic links between countries

• other countries exporting similar products will lose competitiveness
• investors may be unable/unwilling to continue lending to other countries

Question 9

Forces leading to currency crises

Answer 9

2. Rise in foreign interest rate
3. Private sector and banks take an excessive liabilies in foreign currency
4. Taking on excessive short-term debt
5. Running large current account deficits
6. Weak banking system with inadequate supervision and regulation
7. High inflation
8. Global contagion

Question 10

Reasons that investors may lose confidence in a currency?

Answer 10

1. overlending/overborrowing:
   risk of government defoult by debt accumulation.
   overlending to private sector

once there is a risk of default, investors lose confidence

Question 11

What does the DB do to counteract?

Answer 11

Raise interest rates to make domestic assets more attractive

Sell foreign reserve assets against local currency to increase demand

Question 12

What is the reason for speculative attacks?

Answer 12

Investors have nothing to lose (one-way speculative gamble)
they are protected if devaluation happens
If not it’s only a tiny loss from forgoing foreign interest earnings

Question 13

What is a currency crisis?

Answer 13

Serious doubt exist about whether a country’s CB has sufficient foreign exchange reserves to maintain fixed exchange rate.
Often accompanied by a speculative attack
Often culminates a sharp devaluation of the currency or a switch to flexible exchange rates leading to massive depreciation