Understanding Exchange Rate Movements during the 2008 Financial Crisis

During the 2008 financial crisis, many advanced economies, whose banking systems suffered significant capital losses, experienced large and rapid exchange rate depreciations followed by prolonged and gradual appreciation in subsequent periods. In order to understand one possible explanation of these observed exchange rate movements, we develop a simple model of a highly leveraged banking sector in which banks obtain part of their funding from abroad. A fall in bank net worth leads to foreign lenders demanding a higher risk premium on credit supplied to domestic banks. This higher risk premium can be met if the exchange rate experiences an appreciation along the adjustment path, since this raises the value of the bank's earnings in terms of the foreign currency for every period that the foreign risk premium is elevated. In order for the exchange rate to appreciate by a large amount along the adjustment path, it must initially become undervalued - relative to its long-run level - so that in equilibrium the market is willing to bid up its value in subsequent periods. This thus gives rise to the large initial depreciation of the exchange rate followed by its prolonged and gradual appreciation.