WEEK 8 - Economic Models of Crises

Question 1

What are some of the crises that inspired theoretical and empirical discussions?

Answer 1

• > EMS Crisis (1992-93)
• > Asian Crisis (late 1990s)
• > Russian debt default (1999)

Question 2

Why was the crisis models originally developed?

Answer 2

provide an understanding of currency crisis in Latin America in the 1970s and
1980s. (Which used fixed rates)

Question 3

What is the basic argument behind the first gen model?

Answer 3

Krugman (1979) and Flood and Garber (1984) -> Relationship between fixed exchange and inconsistent econ fundamentals (fiscal and monetary policy)

-> Fixed exchange and excessive MS growth pushes crisis -> Then exploited by private sector trying to profit from inconsistent policies

Question 4

What are the assumptions behind the first gen model?

Answer 4

1.Perfect competition
2 Domestic and foreign goods are perfect substitutes,
3 perfect capital mobility, i.e. uncovered interest parity holds at all times,
and
4 PPP holds.

Question 5

What shows that the Money Market is kept in equilibrium at all times? (1st GEN)

Answer 5

Mdt = Mbar st

Where:
Mbar = exogenous

Question 6

What is assumed of the demand of real money balances? (1st GEN)

Answer 6

Assumed to be negatively related to domestic interest:

mdt - pt = - σRt

Question 7

What is domestic money supply made of? (1st GEN)

Answer 7

m = D + R

D = Domestic Credit
R = International Reserves

Question 8

How does the 1st gen model represent PPP?

Answer 8

p = p* + s

or

s = p - p*

Where:
p = National P lvl
p* = Foreign P lvl
s = Spot rate

Question 9

What is the representation showing that perf capital mobility suggest UIP holding continuously (1st GEN)

Answer 9

r = r* + Es dot

Where:
r = domestic interest
r* = foreign interest
Es dot = expected change in interest

Question 10

How does the first gen model represent the relationship between Reserves and Domestic Credit?

Answer 10

R dot = - μ

Showing that as reserves increase, domestic credit falls and vice versa

Since Md constant

Question 11

How do we represent a fixed exchange rate in the 1st gen model?

Answer 11

Es dot = o

Thus making foreign interest:

r* = r

Question 12

Using all the previous equations what is the exchange rate equation? (1ST GEN)

Answer 12

Subbing in Money Mkt equilibrium, Md equation and Ms equation into PPP equation gives:

S bar = R +D - p* + σR*

Question 13

What can we interpret from the relationship between domestic credit and reserves?

Answer 13

Shows that as domestic credit increases, reserves decrease showing that eventually a country exhausts its reserves and has to abandon fixed rate

Question 14

What is a shadow exchange rate?

Answer 14

The floating rate the country would have had if the country did not have a fixed rate

Question 15

When would a speculative attack occur in the 1st gen model?

Answer 15

When the shadow exchange rate = fixed exchange rate

Fall in Money Demand by dm dt = σµ.

SEE GRAPHS EXPLAINING THIS IN NOTES

Question 16

1ST GEN RESULTS OF A SPECULATIVE ATK?

Answer 16

As reserves exhausted, falling by Dr, Ms falls by same amount dms

-> We see a rise in domestic interest (μ) so becomes:

r+ μ

Implying fall in Md, since money mkt in continuous equilibrium Ms falls and so does Md

Question 17

How do we determine the time at which an attack can occur? (1ST GEN)

Answer 17

If R1 (Initial reserves) and T (time before atk, we see:

R1 - μT = -dR

If we rearrange for T gives us:

T = R1 - σμ/μ

Question 18

What factors determine when a speculative attack occurs? (1ST GEN)

Answer 18

Using the equation for the timing of atk we see attack is dependant on:

Initial stock of reserves
Rate of credit expansion

As reserves higher or credit expansion low, the longer the time for a collapse of fixed system

Question 19

Why have the 1st gen model been criticised? (PT 1)

Answer 19

1. Not clear why the level of reserves is critical to the timing of the speculative attack since authorities can use other means to resist the attack, e.g. raising domestic interest rate.
   2 Why would government that operates fixed exchange rate will resort to
   monitisation of its debt?

Question 20

Why have the 1st gen model been criticised? (PT 2)

Answer 20

3 Could not explain the Mexican peso crisis
in the 1990s and the ERM crisis in 1992-3. In the latter, countries such
as France and the UK had pursued a sound monetary fiscal mix but experienced crisis.
4 The models also failed to explain the East Asian crises, which was as a
result of sudden stop of capital in flows and speedy capital outflows

Question 21

What does the 2nd gen model assume?

Answer 21

• > Created by Obstfeld (94) and Flood & Marion (1997,2000)
• > assuming that the second-period monetary policy depends on the government decision on whether or not to devalue in the first period.

Question 22

What are the distinguishing features of the 2nd gen model?

Answer 22

1. More spec of what is a fundamental and can involve any variable which influences policy-makers decision to defend a peg: ->hard fundamentals, such as unemployment, and
   >soft fundamentals, such as the beliefs of foreign exchange market
   participants.
   2 they provide a new theory of self-fulfilling speculation and multiple equilibria.

Question 23

What does the model in the 2nd gen show?

Answer 23

SEE GRAPH IN NOTES

S0 = Shows hard fundamentals and shadow exchange -> Shows atk only after Da

S1 = Shows soft fundamentals, showing that Atk can occur anytime after dB -> When fixed rate dropped equlibrium goes from C to B -> Anywhere from there mkt profit

Question 24

Where does the 2nd gen model fail?

Answer 24

Fails to explain Latin American and Asian Crises of 95 and 97

Question 25

What develops as a result of the failure of the 2nd gen model failures>

Answer 25

Leads to 3rd gen model Grouped together from: 1. moral hazard argument 2 the other is based on bank runs producing a currency crisis.

Question 26

What does the 3rd gen model focus on?

Answer 26

-> Issues relating to financial intermediaries and liquidity effects

Question 27

What do Radelet and Sachs argue in terms of 3rd gen models?

Answer 27

crises in emerging markets are essentially bank runs that work their way through the foreign exchange market.

Question 28

What does another strand of argument say about 3rd gen models of atk?

Answer 28

focussed on the role | of implicit loan guarantees in generating excessively risky investment.

Question 29

When does a form of moral hazard occur in the 3rd gen model?

Answer 29

``` when the unregulated, or loosely regulated, financial intermediaries of a country have some form of government guarantee (either explicit or implicit) ```

Question 30

Continuation of moral hazard argument of 3rd gen model

Answer 30

->the financial intermediaries able to borrow at low (government backed/linked) interest rates and lend at relatively high rates in risky investment projects. ->By inflating the price of these risky assets the intermediaries inflate the asset side of their balance sheets. ->This provokes further lending: a classic bubble process arises. ->When it eventually bursts produces capital flight and sparks a currency crises.

Question 31

What is Krugman variant of the 3rd gen model argue?

Answer 31

Focuses on a balance sheet approach. ->highly leveraged firms holding a large proportion of foreign debt. -> If exogenous capital outflow happen, lead to currency depreciation that eliminates net worth of firms -> In imperfect capital mkts, firms with poor balance sheets can't invest, validating the capital flight SEE NOTES

Question 32

How does Krugman display this model?

Answer 32

Using mundell-flemming model. AD: y = D(y,i) + NX (sP*/P,y) Money Mkt: M/P = L (y,i) UIP: i = i* SEE GRAPH IN NOTES

Question 33

What occurs when firms are balance sheet constrained? (3RD GEN)

Answer 33

y = D(y,i,sP*/P) + NX (sP*/P,y) - > Real exchange rate now affects investment decisions (especially firms with high foreign debt) - > If balance sheet effects high enough to outweight direct traditional NX effect - > The depreciation contractionary If Central bank has fear of floating, then 'leans against the wind': MM equliibrium becomes: M(s)/P = L(y,i) Where M assumed to be decreasing in s

Question 34

What is leaning against the wind?

Answer 34

somewhat higher policy interest rate than what is justified by just achieving the inflation target and stabilising the real economy

Question 35

What is the 3rd gen speculative atk model look like?

Answer 35

SEE GRAPH IN NOTES

Question 36

Why was the asian crises unforeseen?

Answer 36

IMF predicted strong growth for 1998 -> International investor not decline til crises started -> Only in Thailand and Korea that capital in flows started to slow in 1996 -> credit rating of these countries largely remained unchanged in the year before the crises -> Stock mkts in regions reaching new peak in 1997

Question 37

SEE STATS FOR ASIAN CRISIS IN NOTES

Answer 37

SEE STATS FOR ASIAN CRISIS

Question 38

What were some of the external factors of the Asian crises?

Answer 38

->end of the 1980s, Japan went into recession for over two decades with low interest rate that encourages capital outflows into SE Asia -> Chinese devaluation of renimbi by 50% in 94 cited as beginning of loss of cost- competitiveness -> Financial deregulation, attracting large fin invstments in region by large foreign banks -> Believing loans guaranteed by govt (Moral Hazard) -> JP intro of consumption ta , cited as loss of consumer expenditure-> Cited as decline of SE Asia exports in JP

Question 39

What are the weaknesses Mishkin (1999) that the Asian Banking System suffered from?

Answer 39

1. Lax supervision 2. Weak regulation and/or insufficient skills in the regulatory bodies 3. Low capital adequacy ratios 4. Poor project selection schemes and/or corruption in lending practices 5. Inadequate credit-scoring mechanisms and were subject to political manipulation in lending criteria.

Question 40

STATS OF LOANS OF ASIAN CRISIS IN NOTES

Answer 40

SEE IN NOTES

Question 41

What was the IMF Handling of the crisis?

Answer 41

IMF Programme had these objectives: 1.Prevention of default on the part of the Asian countries 2 Prevention of free-fall in their exchange rates 3 Prevention of the emergence of inflation, 4 Maintenance of sound fiscal discipline, 5 Restoration of investor confidence, 6 Structural reform of the financial sector and banking system, 7 Rebuilding of the foreign reserves, 8 Limiting the decline of output.

Question 42

What were some of the instruments the IMF used to achieve these objectives?

Answer 42

1. Bank Closure 2. Fiscal Discipline 3. Monetary Discipline 4. Structural Reform of the banking system

Question 43

What is meant by Bank Closure?

Answer 43

Least viable banks are closed and those remain open should raise the capital to above 8% required by the Basle Accord. ->Thailand, 55 out 91 finance companies were liquidated, ->Korea, 14 out of 30 merchant banks were suspended ->Indonesia, IMF insisted on closure of about 16 banks.

Question 44

What is meant by Fiscal discipline

Answer 44

IMF required that Asian countries should run a budget surplus of about 1% of GDP as it viewed fiscal discipline as crucial in recapitalisation of the banking system and restoration of foreign confidence

Question 45

What is meant by Monetary Discipline?

Answer 45

->limits were set on the creation of domestic credit and interest rates were raised to reduce the capital outflows and ease pressure on the currencies.

Question 46

What is meant by Structural Reform of the banking system?

Answer 46

-> reduction of tariffs and state aid and opening the sector to foreign investment.

Question 47

Why did Radlett and Sachs (1998) criticise the IMF programmes as 'unduly hash'?

Answer 47

Exacerbating the crises, particularly the closure of the banks as it added to credit squeeze and created panic on the international investors that led to bank runs. -> 2/3 Indonesian banks runs by Nov 1997

Question 48

How did Stiglitz (2002) criticise the IMF Programmes?

Answer 48

Tough fiscal discipline along with higher interest rates led to a higher contraction of the economy. The issue of moral hazard and self-fulfilling: IMF intervention causes/worsens crisis.

Question 49

Credit Crunch causes

Answer 49

- > 2001 Mild Recession - > Lower interest rate-> Causing bubble in house prices - > Subprime mortgages -> Defaults - > Fractional banking You know the rest