This is “Currency Crises”, section 15.4 from the book Theory and Applications of Macroeconomics (v. 1.0).
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After you have read this section, you should be able to answer the following questions:
In some countries, the financial crisis of 2008 led to a currency crisisA sudden and unexpected rapid decrease in the value of a currency.. A currency crisis is a sudden and unexpected rapid decrease in the value of a currency. Currency crises are particularly severe in the case of a fixed exchange rateA regime in which a central bank uses its tools to target the value of the domestic currency in terms of a foreign currency. because such crises typically force a monetary authority to abandon the fixed rate. In the case of flexible exchange ratesA system in which market forces determine exchange rates., a currency crisis occurs when the value of the currency decreases substantially in a short period of time. Such rapid depreciation is not as disruptive as the collapse of a fixed exchange rate, but it can still cause significant turmoil in an economy.
If you look at exchange rate data for September and October 2008, you can see that the dollar appreciated relative to the euro at that time. In other words, the dollar price of a euro decreased. Over the 10 days ending October 24, 2008, the dollar price of a euro decreased from about $1.35 to $1.25. More generally, several currencies experienced rapid depreciations during the financial crisis. Though there were no runs on these currencies, they nonetheless lost considerable value.
The dollar value of the British pound decreased to $1.62, its lowest level in 5 years, after the October 21, 2008, announcement that the UK economy was on the brink of a recession. There was a drop in value of about 7 percent over the previous week alone. The pound also decreased against the euro.
A currency crisis can arise from a change in expectations, in ways that are similar to some of our earlier examples. Remember, for instance, how the current value of a house decreases when people expect that its future value will decrease. If you think that the value of Argentine pesos will decline (so each peso will be worth less in dollars), you may respond by selling pesos that you currently own. If everyone in the market shares your beliefs, then everyone will sell, and the value of the peso will decrease now.
If everyone believes that a monetary authority can and will maintain the exchange rate, then people are happy to hold onto a currency. But if people believe that the fixed exchange rate is not sustainable, then there will be a run on the currency. Consider, for example, Brazil trying to stabilize its currency—the real. The monetary authority sets a fixed exchange rate, meaning that it stands ready to exchange Brazilian real for US dollars at a set price. If a fixed exchange rate is set too high, then the Brazilian central bank can maintain this value for a while by buying real with its own stocks of dollars.
But the central bank does not possess unlimited reserves of dollars. If the low demand for the real persists, then eventually the central bank will run out of reserves and thus no longer be able to support the currency. When that happens, the value of the real will have to decrease. A decrease in a fixed exchange rate is called devaluationA decrease in the value of a currency in a fixed exchange rate..
In fact, the decrease in the value of the real would occur well before the central bank runs out of reserves. If you believe that the monetary authority will be forced to abandon the fixed rate, you will take your real and exchange them for dollars—and you will want to do this sooner rather than later to ensure you make the exchange before the real decreases in value. When lots of investors do this, the supply curve for real shifts outward. This makes the problem of maintaining the fixed exchange rate even more difficult for the central bank, so the devaluation of the currency will happen even sooner. If everyone does this, then the monetary authority will not have enough dollars on hand and will have to give up the fixed rate. The risk of such currency crises is the biggest potential problem with fixed exchange rates. History has given us many examples of such crises, and shows that they are very disruptive for the economy—and sometimes even for the world as a whole.
You may have noticed that a currency crisis looks a lot like a bank run. In both cases, pessimistic expectations of investors (about the future of a bank in one case and the future value of a currency in the other) lead them to all behave in a way that makes the pessimism self-fulfilling. In the case of a bank run, if all depositors are worried about their deposits and take their money out of the bank, then the bank fails and the depositors’ pessimism was warranted. Likewise, if investors believe the devaluation of a currency is likely, they will all want to sell their currency. This drives down the price and makes the devaluation much more likely to occur. A currency crisis, like a bank run, is an example of a coordination game.