Financial Fragility and the Exchange Rate Regime

40 Pages Posted: 29 Aug 2000 Last revised: 7 Mar 2021

See all articles by Roberto Chang

Roberto Chang

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences-New Brunswick/Piscataway - Department of Economics; National Bureau of Economic Research (NBER)

Andrés Velasco

Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)

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Date Written: March 1998

Abstract

We study financial fragility, exchange rate crises and monetary policy in an open economy model in which banks are maturity transformers as in Diamond-Dybvig. 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 rate and flexible rates, with and without a lender of last resort. A currency board cannot implement a socially optimal allocation; in addition, under a currency board bank runs are possible. 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. Larger capital inflows enhance welfare if the no-run equilibrium occurs, but may also render the economy more vulnerable to self-fulfilling runs. A flexible exchange rate system implements the social optimum and eliminates runs, provided the exchange rate and central bank lending policies of the central bank are appropriately designed.

Suggested Citation

Chang, Roberto and Velasco, Andrés, Financial Fragility and the Exchange Rate Regime (March 1998). NBER Working Paper No. w6469, Available at SSRN: https://ssrn.com/abstract=226214

Roberto Chang (Contact Author)

Rutgers University, New Brunswick/Piscataway - Faculty of Arts and Sciences-New Brunswick/Piscataway - Department of Economics ( email )

75 Hamilton Street
New Brunswick, NJ 08901
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Andrés Velasco

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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