Financial fragility and the exchange rate regime
AbstractWe study financial fragility, exchange rate crises, and monetary policy in an open economy version of a Diamond-Dybvig model. 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 rates, and flexible rates with and without a lender of last resort. A currency board cannot implement a socially optimal allocation; in addition, bank runs are possible under a currency board. 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. A flexible rate system implements the social optimum and eliminates runs, provided the exchange rate and central bank lending policies are appropriately designed.
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Bibliographic InfoPaper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 97-16.
Date of creation: 1997
Date of revision:
Publication status: Published in Journal of Economic Theory, May 2000
Other versions of this item:
- Chang, R. & Velasco, A., 1998. "Financial Fragility and the Exchange Rate Regime," Working Papers 98-05, C.V. Starr Center for Applied Economics, New York University.
- Roberto Chang & Andres Velasco, 1998. "Financial Fragility and the Exchange Rate Regime," NBER Working Papers 6469, National Bureau of Economic Research, Inc.
- F3 - International Economics - - International Finance
- E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
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