Financial Instability under Floating Exchange Rates
AbstractAt the end of the nineties, many developing countries featured an open capital market and relied heavily on dollar-debt financing of their economy. This paper analyses whether, in this context, clean floating can be a sustainable policy choice. The model is cast as a game between successive generations of investors who decide whether they buy or not the debt of a representative firm. The exchange rate is subject to random shocks, which makes uncertain the private sector’s solvency. We show that a small risk of insolvency would bring about a much larger risk of illiquidity. A rational expectation equilibrium without default can be put forward only in the highly improbable case when the currency is extremely overvalued. The case against flexible exchange rates may be stronger than usually thought.
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Bibliographic InfoPaper provided by ESSEC Research Center, ESSEC Business School in its series ESSEC Working Papers with number DR 03011.
Length: 30 pages
Date of creation: Mar 2003
Date of revision:
Floating; Rational Expectations; Financial Crises; Developing Countries;
Find related papers by JEL classification:
- F30 - International Economics - - International Finance - - - General
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2003-11-03 (All new papers)
- NEP-IFN-2003-11-03 (International Finance)
- NEP-MFD-2003-11-03 (Microfinance)
- NEP-RMG-2003-11-03 (Risk Management)
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