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Liquidity and Twin Crises

  • Hyun Song
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    This paper proposes a simple analytical framework for understanding 'twin crises'- i.e. crises where a currency crisis and banking crisis occur simultaneously and reinforce each other. The distinguishing feature of such crises is the spill-over effects across financial institutions through collateral constraints, declines in market values of assets, currency mismatches on the balance sheet and the endogenous amplification of financial distress through asset sales. We explore the role of liquidity and the role of monetary policy in such crises. In particular, a central question is whether raising interest rates in the face of a twin crisis is the appropriate policy response. Raising interest rates has two countervailing effects. Holding the domestic currency becomes more attractive (other things being equal), but the value of the domestic banking system falls due to the fall in asset prices. When assets are marked to market, there is a potential for endogenously generated financial distress that leads to a collapse of asset prices, as well as the exchange rate. It is thus possible that raising interest rates can have the perverse effect of exacerbating both the currency crisis and the banking crisis. Copyright Banca Monte dei Paschi di Siena SpA, 2005

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    Article provided by Banca Monte dei Paschi di Siena SpA in its journal Economic Notes.

    Volume (Year): 34 (2005)
    Issue (Month): 3 (November)
    Pages: 257-277

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    Handle: RePEc:bla:ecnote:v:34:y:2005:i:3:p:257-277
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    1. Miller, Victoria, 1998. "The Double Drain with a Cross-Border Twist: More on the Relationship between Banking and Currency Crises," American Economic Review, American Economic Association, vol. 88(2), pages 439-43, May.
    2. Reinhart, Carmen & Kaminsky, Graciela, 1999. "The twin crises: The causes of banking and balance of payments problems," MPRA Paper 14081, University Library of Munich, Germany.
    3. Barry Eichengreen & Michael D. Bordo, 2003. "Crises now and then: what lessons from the last era of financial globalization?," Chapters, in: Monetary History, Exchange Rates and Financial Markets, chapter 3 Edward Elgar.
    4. Schnabel, Isabel, 2002. "The German Twin Crisis of 1931," Sonderforschungsbereich 504 Publications 02-48, Sonderforschungsbereich 504, Universit├Ąt Mannheim;Sonderforschungsbereich 504, University of Mannheim.
    5. Martin D. D. Evans and Richard K. Lyons., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance Working Papers RPF-288, University of California at Berkeley.
    6. Rodrigo Cifuentes & Gianluigi Ferrucci & Hyun Song Shin, 2005. "Liquidity risk and contagion," Bank of England working papers 264, Bank of England.
    7. Michael J. Fleming & Eli M. Remolona, 1999. "Price Formation and Liquidity in the U.S. Treasury Market: The Response to Public Information," Journal of Finance, American Finance Association, vol. 54(5), pages 1901-1915, October.
    8. Joon-Ho Hahm & Frederic S. Mishkin, 2000. "Causes of the Korean Financial Crisis: Lessons for Policy," NBER Working Papers 7483, National Bureau of Economic Research, Inc.
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