Question

The first-generation currency crisis models have shown that an exchange rate collapse can be the inevitable result of government policies inconsistent with maintaining a fixed exchange rate permanently. In such cases, simple economic theory may allow us to predict the exact date of a crisis through careful analysis of the government policies and the market’s rational response to them.

(a) Describe with the help of an economic model how the exact date of the exchange rate crisis can be determined in such models. Be sure to describe the policy of the government and the reaction of the Central Bank to that policy in your model. (6 marks)

(b) Draw separate diagrams to illustrate the path of each of the following variables before and after the crisis: exchange rate, money supply, foreign exchange reserves. (5 marks)

Answer 1

a) Economic model exchange rate crisis includes:

1. Fixed exchange rate: Fixed exchange rate is referred to the rate of exchange as fixed by the government.
2. According to the adustable peg system of exchange rate:

• Different currencies were pegged to one currency,, that is US Dollar.
• US Dollar was assigned gold value at a fixed price.
• Value of one currency in terms of US Dollar ultimately implied value of that currency in terms of gold.
• Adjustment in the parity value of a currency was possible only if allowed by IMF.
• Decay of fixed exchange rate system led by scarcity of gold and its unequal availability across different nations on one hand and increasing demand for gold(as a reserve liquid asset) on the other hand.

1. The inconveniences of a fixed exchange rate include:

• Anticipating modifications for monetary forms that become under-or over-esteemed.
• Restricting the degree to which national banks can modify loan costs for financial development.
• Needing an enormous pool of stores to help the money on the off chance that it goes under weight

b) Refer to the diagram

Before the crisis en the crisis Exchange Rate Exchange rate Exchange rate W Supply (Demand (foreign worency) Supply Demand (foreign currency) Foreign Reserves loss of thes s Lovervalued / oss of reserves Foreign currency Appreciates - feg 1 Տպիա [ծ (foreign currency Supply Cover and a 21108264083 ? (undervalued) + - - Domestic Curreancy appreciates : gain of reserves o supply Demand Hanned with damScanner