347
This chapter studies exchange rate crises. It begins by surveying empirical facts about crises and their economic consequences. Then it backtracks to explain the mechanics of how central banks maintain fixed rates. Then it develops both first- and second-generation models of crises.
Exchange Rate Crises: How Pegs Work and How They Break
Global capital markets pose the same kinds of problems that jet planes do. They are faster, more comfortable, and they get you where you are going better. But the crashes are much more spectacular.
Lawrence Summers, U.S. Secretary of the Treasury, 1999
Either extreme: a fixed exchange rate through a currency board, but no central bank, or a central bank plus truly floating exchange rates; either of those is a tenable arrangement. But a pegged exchange rate with a central bank is a recipe for trouble.
Milton Friedman, Nobel laureate, 1998
1. So far we’ve treated fixed rates as stable and sustainable.
2. In fact, most fixed rate regimes don’t last long (an average of five years, a median of two).
3. When a fixed rate regime ends, it usually entails an exchange rate crisis, a large, sudden depreciation that entails high economic and political costs.
4. This chapter studies exchange rate crises, their causes, and their consequences.
In the last chapter, we treated the question “fixed or floating?” as a one-time problem of exchange rate regime choice and assumed that, once the choice was made, the chosen regime would be stable and sustainable.
Unfortunately, the reality is different. The typical fixed exchange rate succeeds for a few years, only to break. A recent study found that the average duration of any peg was about five years, and the median duration was only two years.1 When the break occurs, there is often a large, sudden depreciation accompanied by high economic and political costs. Such a collapse is known as an exchange rate crisis. When a country shifts from floating to fixed it is generally smooth and planned, but when a country shifts from fixed to floating it is typically unplanned and catastrophic.
Despite the fragility exposed by recurrent crises, fixed exchange rate regimes are still in use. Typically, after a crisis, a country that prefers to have a fixed exchange rate will try to peg again: the cycle of crises may continue. Understanding exchange rate crises is a major goal of international macroeconomics because of the damage they do, not only to the country in which the crisis occurs but often to its neighbors and trading partners. In this chapter we learn about exchange rate crises, their causes, and their consequences.
348