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Financial fragility and the exchange rate regime

  • Roberto Chang
  • Andres Velasco

We 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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Paper provided by Federal Reserve Bank of Atlanta in its series FRB Atlanta Working Paper with number 97-16.

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Date of creation: 1997
Date of revision:
Publication status: Published in Journal of Economic Theory, May 2000
Handle: RePEc:fip:fedawp:97-16
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