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Financial Fragility and the Exchange Rate Regime

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  • Chang, Roberto
  • Velasco, Andres

Abstract

We study financial fragility, exchange rate crises and monetary policy in an open economy model in which banks are maturity transformers as in Diamond-Dybvig. The banking system, the exchange rate regime, and central bank credit policy are seen as parts of a mechanism intended to maximize social welfare; if the mechanism fails, banking crises and speculative attacks become possible. We compare currency boards, fixed rate and flexible rates, with and without a lender of last resort. A currency board cannot implement a socially optimal allocation; in addition, under a currency board bank runs are possible. A fixed exchange rate system may implement the social optimum but is more prone to bank runs and exchange rate crises than a currency board. Larger capital inflows enhance welfare if the no-run equilibrium occurs, but may also render the economy more vulnerable to self-fulfilling runs. A flexible exchange rate system implements the social optimum and eliminates runs, provided the exchange rate and central bank lending policies of the central bank are appropriately designed.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 92 (2000)
Issue (Month): 1 (May)
Pages: 1-34

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Handle: RePEc:eee:jetheo:v:92:y:2000:i:1:p:1-34

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Web page: http://www.elsevier.com/locate/inca/622869

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  1. Garber, Peter M. & Svensson, Lars E.O., 1995. "The operation and collapse of fixed exchange rate regimes," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 36, pages 1865-1911 Elsevier.
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