WEEK 8 - Economic Models of Crises Flashcards
What are some of the crises that inspired theoretical and empirical discussions?
- > EMS Crisis (1992-93)
- > Asian Crisis (late 1990s)
- > Russian debt default (1999)
Why was the crisis models originally developed?
provide an understanding of currency crisis in Latin America in the 1970s and
1980s. (Which used fixed rates)
What is the basic argument behind the first gen model?
Krugman (1979) and Flood and Garber (1984) -> Relationship between fixed exchange and inconsistent econ fundamentals (fiscal and monetary policy)
-> Fixed exchange and excessive MS growth pushes crisis -> Then exploited by private sector trying to profit from inconsistent policies
What are the assumptions behind the first gen model?
1.Perfect competition
2 Domestic and foreign goods are perfect substitutes,
3 perfect capital mobility, i.e. uncovered interest parity holds at all times,
and
4 PPP holds.
What shows that the Money Market is kept in equilibrium at all times? (1st GEN)
Mdt = Mbar st
Where:
Mbar = exogenous
What is assumed of the demand of real money balances? (1st GEN)
Assumed to be negatively related to domestic interest:
mdt - pt = - σRt
What is domestic money supply made of? (1st GEN)
m = D + R
D = Domestic Credit R = International Reserves
How does the 1st gen model represent PPP?
p = p* + s
or
s = p - p*
Where:
p = National P lvl
p* = Foreign P lvl
s = Spot rate
What is the representation showing that perf capital mobility suggest UIP holding continuously (1st GEN)
r = r* + Es dot
Where:
r = domestic interest
r* = foreign interest
Es dot = expected change in interest
How does the first gen model represent the relationship between Reserves and Domestic Credit?
R dot = - μ
Showing that as reserves increase, domestic credit falls and vice versa
Since Md constant
How do we represent a fixed exchange rate in the 1st gen model?
Es dot = o
Thus making foreign interest:
r* = r
Using all the previous equations what is the exchange rate equation? (1ST GEN)
Subbing in Money Mkt equilibrium, Md equation and Ms equation into PPP equation gives:
S bar = R +D - p* + σR*
What can we interpret from the relationship between domestic credit and reserves?
Shows that as domestic credit increases, reserves decrease showing that eventually a country exhausts its reserves and has to abandon fixed rate
What is a shadow exchange rate?
The floating rate the country would have had if the country did not have a fixed rate
When would a speculative attack occur in the 1st gen model?
When the shadow exchange rate = fixed exchange rate
Fall in Money Demand by dm dt = σµ.
SEE GRAPHS EXPLAINING THIS IN NOTES
1ST GEN RESULTS OF A SPECULATIVE ATK?
As reserves exhausted, falling by Dr, Ms falls by same amount dms
-> We see a rise in domestic interest (μ) so becomes:
r+ μ
Implying fall in Md, since money mkt in continuous equilibrium Ms falls and so does Md
How do we determine the time at which an attack can occur? (1ST GEN)
If R1 (Initial reserves) and T (time before atk, we see:
R1 - μT = -dR
If we rearrange for T gives us:
T = R1 - σμ/μ
What factors determine when a speculative attack occurs? (1ST GEN)
Using the equation for the timing of atk we see attack is dependant on:
Initial stock of reserves
Rate of credit expansion
As reserves higher or credit expansion low, the longer the time for a collapse of fixed system
Why have the 1st gen model been criticised? (PT 1)
- Not clear why the level of reserves is critical to the timing of the speculative attack since authorities can use other means to resist the attack, e.g. raising domestic interest rate.
2 Why would government that operates fixed exchange rate will resort to
monitisation of its debt?
Why have the 1st gen model been criticised? (PT 2)
3 Could not explain the Mexican peso crisis
in the 1990s and the ERM crisis in 1992-3. In the latter, countries such
as France and the UK had pursued a sound monetary fiscal mix but experienced crisis.
4 The models also failed to explain the East Asian crises, which was as a
result of sudden stop of capital in flows and speedy capital outflows
What does the 2nd gen model assume?
- > Created by Obstfeld (94) and Flood & Marion (1997,2000)
- > assuming that the second-period monetary policy depends on the government decision on whether or not to devalue in the first period.
What are the distinguishing features of the 2nd gen model?
- More spec of what is a fundamental and can involve any variable which influences policy-makers decision to defend a peg: ->hard fundamentals, such as unemployment, and
>soft fundamentals, such as the beliefs of foreign exchange market
participants.
2 they provide a new theory of self-fulfilling speculation and multiple equilibria.
What does the model in the 2nd gen show?
SEE GRAPH IN NOTES
S0 = Shows hard fundamentals and shadow exchange -> Shows atk only after Da
S1 = Shows soft fundamentals, showing that Atk can occur anytime after dB -> When fixed rate dropped equlibrium goes from C to B -> Anywhere from there mkt profit
Where does the 2nd gen model fail?
Fails to explain Latin American and Asian Crises of 95 and 97
What develops as a result of the failure of the 2nd gen model failures>
Leads to 3rd gen model
Grouped together from:
1. moral hazard argument
2 the other is based on bank runs producing a currency crisis.
What does the 3rd gen model focus on?
-> Issues relating to financial intermediaries and liquidity effects
What do Radelet and Sachs argue in terms of 3rd gen models?
crises in emerging markets are
essentially bank runs that work their way through the foreign
exchange market.
What does another strand of argument say about 3rd gen models of atk?
focussed on the role
of implicit loan guarantees in generating excessively risky investment.
When does a form of moral hazard occur in the 3rd gen model?
when the unregulated, or loosely regulated, financial intermediaries of a country have some form of government guarantee (either explicit or implicit)
Continuation of moral hazard argument of 3rd gen model
->the financial intermediaries able to borrow at low (government backed/linked) interest rates and lend at
relatively high rates in risky investment projects.
->By inflating the price of these risky assets the intermediaries inflate
the asset side of their balance sheets.
->This provokes further lending: a classic bubble process arises.
->When it eventually bursts produces capital flight and sparks a currency crises.
What is Krugman variant of the 3rd gen model argue?
Focuses on a
balance sheet approach.
->highly leveraged firms holding a large proportion of foreign debt.
-> If exogenous capital outflow happen, lead to currency depreciation that eliminates net worth of firms
-> In imperfect capital mkts, firms with poor balance sheets can’t invest, validating the capital flight
SEE NOTES
How does Krugman display this model?
Using mundell-flemming model.
AD: y = D(y,i) + NX (sP/P,y)
Money Mkt: M/P = L (y,i)
UIP: i = i
SEE GRAPH IN NOTES
What occurs when firms are balance sheet constrained? (3RD GEN)
y = D(y,i,sP/P) + NX (sP/P,y)
- > Real exchange rate now affects investment decisions (especially firms with high foreign debt)
- > If balance sheet effects high enough to outweight direct traditional NX effect
- > The depreciation contractionary
If Central bank has fear of floating, then ‘leans against the wind’:
MM equliibrium becomes:
M(s)/P = L(y,i)
Where M assumed to be decreasing in s
What is leaning against the wind?
somewhat higher policy interest rate than what is justified by just achieving the inflation target and stabilising the real economy
What is the 3rd gen speculative atk model look like?
SEE GRAPH IN NOTES
Why was the asian crises unforeseen?
IMF predicted strong growth for 1998
-> International investor not decline til crises started
-> Only in Thailand and Korea that capital in flows started to slow in 1996
-> credit rating of these countries largely remained
unchanged in the year before the crises
-> Stock mkts in regions reaching new peak in 1997
SEE STATS FOR ASIAN CRISIS IN NOTES
SEE STATS FOR ASIAN CRISIS
What were some of the external factors of the Asian crises?
->end of the 1980s,
Japan went into recession for over two decades with low interest rate that encourages capital outflows into SE Asia
-> Chinese devaluation of renimbi by 50% in 94 cited as beginning of loss of cost- competitiveness
-> Financial deregulation, attracting large fin invstments in region by large foreign banks -> Believing loans guaranteed by govt (Moral Hazard)
-> JP intro of consumption ta , cited as loss of consumer expenditure-> Cited as decline of SE Asia exports in JP
What are the weaknesses Mishkin (1999) that the Asian Banking System suffered from?
- Lax supervision
- Weak regulation and/or insufficient skills in the regulatory bodies
- Low capital adequacy ratios
- Poor project selection schemes and/or corruption in lending practices
- Inadequate credit-scoring mechanisms and were subject to political
manipulation in lending criteria.
STATS OF LOANS OF ASIAN CRISIS IN NOTES
SEE IN NOTES
What was the IMF Handling of the crisis?
IMF Programme had these objectives:
1.Prevention of default on the part of the Asian countries
2 Prevention of free-fall in their exchange rates
3 Prevention of the emergence of inflation,
4 Maintenance of sound fiscal discipline,
5 Restoration of investor confidence,
6 Structural reform of the financial sector and banking system,
7 Rebuilding of the foreign reserves,
8 Limiting the decline of output.
What were some of the instruments the IMF used to achieve these objectives?
- Bank Closure
- Fiscal Discipline
- Monetary Discipline
- Structural Reform of the banking system
What is meant by Bank Closure?
Least viable banks are closed and those remain open should raise the capital to above 8% required by the Basle Accord.
->Thailand, 55 out 91 finance companies were liquidated,
->Korea, 14 out of 30 merchant banks were suspended
->Indonesia, IMF
insisted on closure of about 16 banks.
What is meant by Fiscal discipline
IMF required that Asian
countries should run a budget surplus of about 1% of GDP as it viewed
fiscal discipline as crucial in recapitalisation of the banking system and
restoration of foreign confidence
What is meant by Monetary Discipline?
->limits were set on the creation of domestic credit
and interest rates were raised to reduce the capital outflows and ease
pressure on the currencies.
What is meant by Structural Reform of the banking system?
-> reduction of tariffs and state aid and opening the sector to foreign investment.
Why did Radlett and Sachs (1998) criticise the IMF programmes as ‘unduly hash’?
Exacerbating the crises, particularly the closure of
the banks as it added to credit squeeze and created panic on the
international investors that led to bank runs.
-> 2/3 Indonesian banks runs by Nov 1997
How did Stiglitz (2002) criticise the IMF Programmes?
Tough fiscal discipline along with higher interest rates led to a higher contraction of the economy.
The issue of moral hazard and self-fulfilling: IMF intervention
causes/worsens crisis.
Credit Crunch causes
- > 2001 Mild Recession
- > Lower interest rate-> Causing bubble in house prices
- > Subprime mortgages -> Defaults
- > Fractional banking
You know the rest
