Browsing by Subject "financial crisis"

The East Asian crisis of the 1990s was the result of a rapid economic expansion that stemmed from the liberalization of financial markets and growth promoting policies, which at the same time rendered the economies vulnerable to financial crises. In the wake of the crisis, the previous currency crisis models have been questioned for their usefulness in explaining the East Asian crisis. As a result, a third generation of currency crisis models have emerged, which emphasize the role of private sector balance sheets as the primary cause of the crisis. This thesis aims to study the causes of the crisis and capture its fundamental characteristics in a theoretical framework. The thesis considers a third-generation currency crisis model, in which nominal price rigidities, foreign currency liabilities in the private sector’s balance-sheets and borrowing constraints make the economy vulnerable to currency crises. At the heart of the model is the possibility of multiple equilibria, i.e., currency crises may be triggered by expectational shocks. If domestic prices are rigid in the short-run, a currency depreciation increases the value of foreign currency debt and decreases the private sector’s profits and net wealth. Since private sector borrowing and output are positively correlated with profits, a depreciation of the domestic currency decreases future output. Due to arbitrage in the foreign currency market, a decrease in future output causes the domestic currency to depreciate immediately. Therefore, if agents in the economy expect the currency to depreciate, the currency may in fact depreciate, and thus, an expectational shock may push the economy to a currency crisis equilibrium. The mathematical models presented in this paper are general equilibrium models. The primary sources of the thesis are the articles by Aghion et al. (2000, 2001, 2004), Bergman & Hassan (2008) and Ormaechea (2010). In addition, the thesis discusses the appropriate monetary policy to prevent this type of currency crises. It is shown that the central bank may prevent a currency crisis by supporting the nominal exchange rate by tightening monetary policy, if it does not hurt supply of credit to domestic banks. Hence, tight monetary policy is optimal if the benefits of a higher nominal exchange rate outweigh the costs of decreased borrowing and investment. It is also shown that the central bank alleviate the adverse effect on investment by supplying credit to domestic banks via the discount window. Furthermore, the thesis finds that tight monetary policy is optimal if the uncovered interest rate parity holds in the short-run. If monetary policy is unable to influence the nominal exchange rate, then loose monetary policy is optimal in preventing this type of currency crisis. The thesis finds that the fundamental reasons for the East-Asian crisis were substantial foreign currency borrowing as well as less developed financial markets. The theoretical model reveals that a high proportion of foreign currency liabilities relative to liabilities denominated in the domestic currency make the economy more vulnerable to a currency crisis, because it increases the adverse balance-sheet effects related to a depreciation. However, the less rigid prices are in the short-run, the less vulnerable the economy is to a currency crisis. If changes in the nominal exchange rate are passed through to domestic prices, the adverse effects of depreciation become less severe.