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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
Date of revision:
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. 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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  7. Obstfeld, Maurice, 1991. "Destabilizing Effects of Exchange-Rate Escape Clauses," CEPR Discussion Papers 518, C.E.P.R. Discussion Papers.
  8. 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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  12. Michael Gavin & Ricardo Hausmann, 1996. "The Roots of Banking Crises: The Macroeconomic Context," Research Department Publications 4026, Inter-American Development Bank, Research Department.
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  22. Sebastian Edwards & Carlos A. Végh, 1997. "Banks and Macroeconomic Disturbances Under Predetermined Exchange Rates," CEMA Working Papers: Serie Documentos de Trabajo. 115, Universidad del CEMA.
  23. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August.
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  36. Garber, Peter M. & Grilli, Vittorio U., 1986. "The Belmont-Morgan Syndicate as an optimal investment banking contract," European Economic Review, Elsevier, vol. 30(3), pages 649-677, June.
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