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Financial Crises and the Benefits of Mildly Repressed Exchange Rates

  • Yotopoulos, Pan A.

    ()

    (Food Research Institute)

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    The devaluation of the Mexican peso of 1995 along with the more recent financial crises in emerging economies are viewed as systematic outcomes of the operation of free currency markets. The hypothesis is that there exists a distortion in free currency markets that makes developing countries systematically misallocate resources. The distortion lies in "asymmetric reputation" that leads to substitution of the reserve currency for the country's soft currency in liquid asset holdings, thus making systemic devaluations inevitable. Moreover, the empirical analysis shows that currency-substitution-led endemic devaluations misallocate resources in competitive devaluation trade, as opposed to comparative advantage trade. In a case that is parallel to asymmetric information and incomplete credit markets, the appropriate policy intervention in asymmetric-reputation driven incomplete currency markets is maintaining mildly repressed exchange rates. The operational definition of "mild" is imposing restrictions on the home-grown variety of currency substitution.

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    Paper provided by Stockholm School of Economics in its series SSE/EFI Working Paper Series in Economics and Finance with number 202.

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    Length: 21 pages
    Date of creation: 27 Oct 1997
    Date of revision:
    Handle: RePEc:hhs:hastef:0202
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