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Contractionary Currency Crashes In Developing Countries

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Frankel, Jeffrey (Harvard U)

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Abstract

To update a famous old statistic: a political leader in a developing country is twice as likely to lose office in the 6 months following a currency crash as otherwise. This difference, which is highly significant statistically, holds regardless whether the devaluation takes place in the context of an IMF program. Why are devaluations so costly? Many of the currency crises of the last ten years have been associated with output loss. Is this, as alleged, because of excessive reliance on raising the interest rate as a policy response? More likely it is because of contractionary effects of devaluation. There are various possible contractionary effects of devaluation, but it is appropriate that the balance sheet effect receives the most emphasis. Passthrough from exchange rate changes to import prices in developing countries is not the problem: this coefficient fell in the 1990s, as a look at some narrowly defined products shows. Rather, balance sheets are the problem. How can countries mitigate the fall in output resulting from the balance sheet effect in crises? In the shorter term, adjusting promptly after inflows cease is better than procrastinating by shifting to short-term dollar debt, which raises the costliness of the devaluation when it finally comes. In the longer term, greater openness to trade reduces vulnerability to both sudden stops and currency crashes.

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Paper provided by Harvard University, John F. Kennedy School of Government in its series Working Paper Series with number rwp05-017.

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Date of creation: May 2005
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Handle: RePEc:ecl:harjfk:rwp05-017

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References listed on IDEAS
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. García-Fronti, Javier & Miller, Marcus & Zhang, Lei, 2006. "Supply Shocks and Currency Crises: The Policy Dilemma Reconsidered," CEPR Discussion Papers 5905, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  2. Saki Bigio & Marco Vega, 2006. "Monetary Policy under Balance Sheet Uncertainty," Computing in Economics and Finance 2006 157, Society for Computational Economics. [Downloadable!]
  3. Eduardo Levy Yeyati, 2006. "Exchange Rate Regimes in the 2000s: A Latin American Perspective," Business School Working Papers exchangerate, Universidad Torcuato Di Tella. [Downloadable!]
  4. Axel Dreher & Stefanie Walter, 2008. "Does the IMF Help or Hurt? The Effect of IMF programs on the likelihood and outcome of currency crises," Working papers 08-186, KOF Swiss Economic Institute, ETH Zurich. [Downloadable!]
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  6. Jianhuai Shi, 2006. "Are Currency Appreciations Contractionary in China?," NBER Working Papers 12551, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  7. Makram El-Shagi, 2009. "The Impact of Fixed Exchange Rates on Fiscal Discipline," cege – Center for European, Governance and Economic Development Research Discussion Papers 84, cege – Center for European, Governance and Economic Development Research, University of Goettingen (Germany)., revised 08 Jun 2009. [Downloadable!]
  8. Presbitero, Andrea F., 2006. "The debt-growth nexus in poor countries: a reassessment," Proceedings of the German Development Economics Conference, Berlin 2006 22, Verein für Socialpolitik, Research Committee Development Economics. [Downloadable!]
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  9. PATHAK, Parag & TIROLE, Jean, 2006. "Speculative Attacks and Risk Management," IDEI Working Papers 438, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
  10. Michael M. Hutchison & Ilan Noy & Lidan Wang, 2007. "Fiscal and Monetary Policies and the Cost of Sudden Stops," Working Papers 200724, University of Hawaii at Manoa, Department of Economics. [Downloadable!]
  11. Michael Bleaney & F. Gulcin Ozkan, . "Foreign Debt and Fear of Floating: A Theoretical Exploration," Discussion Papers 08/03, University of Nottingham, School of Economics. [Downloadable!]
  12. Sánchez-Fung, José R., 2008. "The day-to-day interbank market, volatility, and central bank intervention in a developing economy," MPRA Paper 15648, University Library of Munich, Germany. [Downloadable!]
  13. Eduardo A. Cavallo & Alberto Cavallo, 2008. "Are Crises Good for Long-Term Growth? The Role of Political Institutions," RES Working Papers 4589, Inter-American Development Bank, Research Department. [Downloadable!]
  14. Törbjörn I. Becker & Paolo Mauro, 2006. "Output Drops and the Shocks That Matter," IMF Working Papers 06/172, International Monetary Fund. [Downloadable!]
  15. Eduardo A. Cavallo & Alberto Cavallo, 2008. "¿Son Buenas las Crisis para el Crecimiento a Largo Plazo? El Papel de las Instituciones Políticas," RES Working Papers 4590, Inter-American Development Bank, Research Department. [Downloadable!]
  16. Michael Bleaney & F. Gulcin Ozkan, 2008. "Foreign Debt and Fear of Floating: A Theoretical Exploration," Discussion Papers 08/10, Department of Economics, University of York. [Downloadable!]
  17. Bedri Kamil Onur Tas & Selahattin Togay, 2008. "Optimal Monetary Policy for Postwar Iraq," Working Papers 0813, TOBB University of Economics and Technology, Department of Economics. [Downloadable!]
  18. García-Fronti, Javier & Miller, Marcus & Zhang, Lei, 2005. "Credit Crunch and Keynesian Contraction: Argentina in Crisis," CEPR Discussion Papers 4889, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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