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Financial Instability under Floating Exchange Rates

At the end of the nineties, many developing countries featured an open capital market and relied heavily on dollar-debt financing of their economy. This paper analyses whether, in this context, clean floating can be a sustainable policy choice. The model is cast as a game between successive generations of investors who decide whether they buy or not the debt of a representative firm. The exchange rate is subject to random shocks, which makes uncertain the private sector’s solvency. We show that a small risk of insolvency would bring about a much larger risk of illiquidity. A rational expectation equilibrium without default can be put forward only in the highly improbable case when the currency is extremely overvalued. The case against flexible exchange rates may be stronger than usually thought.

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Paper provided by ESSEC Research Center, ESSEC Business School in its series ESSEC Working Papers with number DR 03011.

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Length: 30 pages
Date of creation: Mar 2003
Date of revision:
Handle: RePEc:ebg:essewp:dr-03011
Contact details of provider: Postal: ESSEC Research Center, BP 105, 95021 Cergy, France
Web page: http://www.essec.edu/
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  1. Herwartz, Helmut & Reimers, Hans-Eggert, 2002. "Testing the purchasing power parity in pooled systems of error correction models," Japan and the World Economy, Elsevier, vol. 14(1), pages 45-62, January.
  2. Rapach, David E. & Wohar, Mark E., 2002. "Testing the monetary model of exchange rate determination: new evidence from a century of data," Journal of International Economics, Elsevier, vol. 58(2), pages 359-385, December.
  3. Masson, Paul, 1999. "Contagion:: macroeconomic models with multiple equilibria," Journal of International Money and Finance, Elsevier, vol. 18(4), pages 587-602, August.
  4. Sebastian Edwards, 2002. "The Great Exchange Rate Debate after Argentina," Working Papers 74, Oesterreichische Nationalbank (Austrian Central Bank).
  5. Cowan, kevin & Quy-Toan Do, 2003. "Financial dollarization and central bank credibility," Policy Research Working Paper Series 3082, The World Bank.
  6. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  7. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
  8. Kenneth Rogoff, 1999. "International Institutions for Reducing Global Financial Instability," Journal of Economic Perspectives, American Economic Association, vol. 13(4), pages 21-42, Fall.
  9. Harold L. Cole & Timothy J. Kehoe, 1998. "Self-fulfilling debt crises," Staff Report 211, Federal Reserve Bank of Minneapolis.
  10. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May.
  11. Jeffrey A. Frankel, 1999. "No Single Currency Regime is Right for All Countries or At All Times," NBER Working Papers 7338, National Bureau of Economic Research, Inc.
  12. Ize, Alain & Yeyati, Eduardo Levy, 2003. "Financial dollarization," Journal of International Economics, Elsevier, vol. 59(2), pages 323-347, March.
  13. Besancenot, Damien & Huynh, Kim & Vranceanu, Radu, 2004. "Default on sustainable public debt: illiquidity suspect convicted," Economics Letters, Elsevier, vol. 82(2), pages 205-211, February.
  14. Banerjee, Abhijit & Bacchetta, Philippe & Aghion, Philippe, 2001. "Currency Crises and Monetary Policy in an Economy with Credit Constraints," Scholarly Articles 4554218, Harvard University Department of Economics.
  15. Stanley Fischer, 2001. "Exchange Rate Regimes: Is the Bipolar View Correct?," Journal of Economic Perspectives, American Economic Association, vol. 15(2), pages 3-24, Spring.
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