Exchange Rates and Financial Fragility

Abstract

In this paper we analyze three views of the relationship between the exchange rate and financial fragility: (1) the moral hazard hypothesis, according to which pegged exchange rates offer implicit insurance against exchange risk and thereby encourage reckless borrowing and lending; (2) the original sin hypothesis, which emphasizes an incompleteness in financial markets which prevents the domestic currency from being used to borrow abroad or to borrow long term even domestically; and (3) the commitment problem hypothesis, which sees financial crises as resulting from neither moral hazard nor original sin but from the weakness of the institutions that address commitment problems. We examine the evidence on these hypotheses and draw out their implications for exchange-rate policy in emerging markets.