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Exchange Rate Stability and Financial Stability

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  • Eichengreen, Barry

Abstract

In this paper I consider the connections between the exchange rate and the financial system, focusing on the implications of international monetary arrangements for the stability of the banking system. I ask questions like the following. Under what conditions can a currency peg jeopardize the stability of the banking system? Can adopting a peg set in motion processes that weaken the banks, themselves the linchpin of the financial system? Once the banking system weakens, how serious an obstacle is the currency peg to lender-of-last-resort intervention? While this review of the historical record shows that there is no simple mapping between exchange rate stability and financial stability, it confirms that the textbook insight about the origin of disturbances and the advantages of fixed and floating rates remains the obvious place to start. When disturbances are imported, a flexible rate provides useful insulation; when they are domestic, exchange rate stability allows them to be shared with the rest of the world and disciplines domestic policymakers. This simple logic applies directly to the stability of the banking system. When disturbances to the banking system originate abroad, exchange rate flexibility can help to insulate the banks from shocks to their funding and investments. It gives the authorities the opportunity to act as lenders of last resort. The Great Depression provides perhaps the clearest illustration: in the 1930s most countries experienced the contraction of credit and collapse of activity as an imported shock, and those which allowed their exchange rates to adjust, decoupling domestic monetary and financial conditions from those abroad, were best able to avert banking panics, and to engage in lenderof- last-resort operations. Conversely, when macroeconomic and financial shocks jeopardizing the stability of the banking system are home grown, pegging the exchange rate allows idiosyncratic disturbances to spill out into the rest of the world and imposes discipline on domestic policymakers. Argentina in the 1990s illustrates the point: by adopting a rigid currency peg it has prevented domestic policymakers from succumbing to the monetary and fiscal excesses that long destabilized its banking system.

Suggested Citation

  • Eichengreen, Barry, 1997. "Exchange Rate Stability and Financial Stability," Center for International and Development Economics Research (CIDER) Working Papers 233612, University of California-Berkeley, Department of Economics.
  • Handle: RePEc:ags:ucbewp:233612
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    References listed on IDEAS

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    Cited by:

    1. Ricardo Hausmann & Michael Gavin & Carmen Pagés & Ernesto H. Stein, 1999. "Financial Turmoil and the Choice of Exchange Rate Regime," IDB Publications (Working Papers) 1108, Inter-American Development Bank.
    2. Domac, Ilker & Martinez Peria, Maria Soledad, 2003. "Banking crises and exchange rate regimes: is there a link?," Journal of International Economics, Elsevier, vol. 61(1), pages 41-72, October.
    3. Michele Fratianni & Dominick Salvatore & Paolo Savona, 1998. "Ideas for the Future of the International Monetary System: Conclusions and Remarks," Open Economies Review, Springer, vol. 9(1), pages 689-700, January.
    4. Aguirre, Maria Sophia & Saidi, Reza, 2004. "Japanese banks liability management before and during the banking crises and macroeconomic fundamentals," Journal of Asian Economics, Elsevier, vol. 15(2), pages 373-397, April.
    5. Koichi Hamada, 1998. "The Choice of International Monetary Regimes in a Context of Repeated Games," Open Economies Review, Springer, vol. 9(1), pages 417-446, January.
    6. Gerardo della Paolera & Alan M. Taylor, 1999. "Internal Versus External Convertibility and Developing-Country FinancialCrises: Lessons from the Argentine Bank Bailout of the 1930's," NBER Working Papers 7386, National Bureau of Economic Research, Inc.
    7. Alberto Predieri, 1998. "Money Markets and Poliarchic Democratic States," Open Economies Review, Springer, vol. 9(1), pages 713-726, January.
    8. Forrest Capie, 1998. "Monetary Unions in Historical Perspective: What Future for the Euro in the International Financial System," Open Economies Review, Springer, vol. 9(1), pages 447-466, January.
    9. Deabes, Tosson, 2003. "How to Reduce the Risk Of Banking Problems," MPRA Paper 3054, University Library of Munich, Germany, revised Nov 2003.
    10. Honohan, P. & Lane, P.R., 2000. "Will the Euro Trigger More Monetary Unions in Africa?," Research Paper 176, World Institute for Development Economics Research.
    11. Dominick Salvatore, 1998. "International Monetary and Financial Arrangements: Present and Future," Open Economies Review, Springer, vol. 9(1), pages 375-416, January.
    12. Eichengreen, Barry & Rose, Andrew K, 1998. "Staying Afloat When the Wind Shifts: External Factors and Emerging-Market Banking Crises," CEPR Discussion Papers 1828, C.E.P.R. Discussion Papers.
    13. Paolo Savona & Aurelio Maccario, 1998. "On the Relation between Money and Derivatives and its Application to the International Monetary Market," Open Economies Review, Springer, vol. 9(1), pages 637-664, January.
    14. Gerardo della Paolera & Alan M. Taylor, 2000. "Internal Versus External Convertibility and Developing-Country Financial," Macroeconomics 0004002, University Library of Munich, Germany.
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    16. Tyrowicz, Joanna, 2009. "When Eastern Labour Markets Enter Western Europe CEECs. Labour Market Institutions upon Euro Zone Accession," MPRA Paper 15045, University Library of Munich, Germany.
    17. Karl Betz, 1999. "Finanzkrisen und Dollarisierung," Vierteljahrshefte zur Wirtschaftsforschung / Quarterly Journal of Economic Research, DIW Berlin, German Institute for Economic Research, vol. 68(1), pages 68-75.
    18. Alicia García Herrero & Pedro del Río, 2003. "Financial stability and the design of monetary policy," Working Papers 0315, Banco de España;Working Papers Homepage.
    19. Kristina Spantig, 2015. "International monetary policy spillovers—can the RMB and the euro challenge the hegemony of the US dollar?," Asia Europe Journal, Springer, vol. 13(4), pages 459-478, December.
    20. Sanchis, A. & Segovia, M.J. & Gil, J.A. & Heras, A. & Vilar, J.L., 2007. "Rough Sets and the role of the monetary policy in financial stability (macroeconomic problem) and the prediction of insolvency in insurance sector (microeconomic problem)," European Journal of Operational Research, Elsevier, vol. 181(3), pages 1554-1573, September.

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    Keywords

    Financial Economics;

    JEL classification:

    • O2 - Economic Development, Innovation, Technological Change, and Growth - - Development Planning and Policy

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