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Exchange Rate Stability and Financial Stability

  • Barry Eichengreen.

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 lender-of-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.

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Paper provided by University of California at Berkeley in its series Center for International and Development Economics Research (CIDER) Working Papers with number C97-092.

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Date of creation: 01 Jun 1997
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Handle: RePEc:ucb:calbcd:c97-092
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  1. Barry Eichengreen and Marc Flandreau., 1994. "The Geography of the Gold Standard," Center for International and Development Economics Research (CIDER) Working Papers C94-042, University of California at Berkeley.
  2. Maurice Obstfeld, 1991. "Destabilizing Effects of Exchange-Rate Escape Clauses," NBER Working Papers 3603, National Bureau of Economic Research, Inc.
  3. Dominguez, Kathryn M & Frankel, Jeffrey A, 1993. "Does Foreign-Exchange Intervention Matter? The Portfolio Effect," American Economic Review, American Economic Association, vol. 83(5), pages 1356-69, December.
  4. Gerardo della Paolera and Alan M. Taylor., 1997. "Finance and Development in an Emerging Market: Argentina in the Interwar Period," Center for International and Development Economics Research (CIDER) Working Papers C97-089, University of California at Berkeley.
  5. Reinhart, Carmen & Kaminsky, Graciela, 2000. "Las crisis gemelas: las causas de los problemas bancarios y de balanza de pagos
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  7. Sebastian Edwards & Carlos A. Vegh, 1997. "Banks and Macroeconomics Disturbances under Predetermined Exchange Rates," NBER Working Papers 5977, National Bureau of Economic Research, Inc.
  8. Michael D. Bordo, 1995. "The Gold Standard as a `Good Housekeeping Seal of Approval'," NBER Working Papers 5340, National Bureau of Economic Research, Inc.
  9. Lawrence J. White, 1992. "Change and Turmoil in U.S. Banking: Causes, Consequences, and Lessons," Working Papers 92-19, New York University, Leonard N. Stern School of Business, Department of Economics.
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  12. Richard H. Timberlake, 1963. "Mr. Shaw and His Critics: Monetary Policy in the Golden Era Reviewed," The Quarterly Journal of Economics, Oxford University Press, vol. 77(1), pages 40-54.
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  14. Kathryn Dominguez & Jeffrey A. Frankel, 1990. "Does Foreign Exchange Intervention Work?," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 16.
  15. Eichengreen, Barry, 1995. "Central bank co-operation and exchange rate commitments: the classical and interwar gold standards compared," Financial History Review, Cambridge University Press, vol. 2(02), pages 99-117, October.
  16. Wigmore, Barrie A., 1987. "Was the Bank Holiday of 1933 Caused by a Run on the Dollar?," The Journal of Economic History, Cambridge University Press, vol. 47(03), pages 739-755, September.
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  18. Epstein, Gerald & Ferguson, Thomas, 1984. "Monetary Policy, Loan Liquidation, and Industrial Conflict: The Federal Reserve and the Open Market Operations of 1932," The Journal of Economic History, Cambridge University Press, vol. 44(04), pages 957-983, December.
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  27. repec:idb:wpaper:321 is not listed on IDEAS
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  36. Bordo Michael D. & Kydland Finn E., 1995. "The Gold Standard As a Rule: An Essay in Exploration," Explorations in Economic History, Elsevier, vol. 32(4), pages 423-464, October.
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