Comprehensive Examinations-Iped-Monetary Policy

II.B-Section 2

a. The first generation models (1G) is concerned with the circumstances in which a balance of payment (BoP) problem (i.e. a country’s gradually loss of reserves) evolves into a BoP crisis in which speculators attack the currency. These crises are a natural outcome of maximizing behavior by investors. When the government’s willingness to use reserves to defend the exchange rate is uncertain, there can be a series of crises in which capital flows out of the country, then returns, before the issue is finally resolved. However, Krugman’s analysis have two major limitations: (i) it is based on a highly simplified macro-model, thus not covering all the factors that could trigger a BoP crisis; and (ii) the assumption that only two assets are available places an unrealistic constraint on the possible actions of the government because the only way it can peg the exchange rate is by selling its reserves, hence, other policies should be considered (i.e. open-market sales of securities, intervention in the forward market, etc.). Nevertheless the model explains why efforts to defend the fixed exchange rates so often lead to crises. Self-fulfilling crisis lies in the center of the second generation models

(2G). The self-fulfilling mechanism complements the 1G, under which a country’s currency is attacked by speculators if and only if fundamental inconsistency exists in domestically policies (i.e. inflationary budget deficits and fixed exchange rate).  2G offers two alternatives by which a fixed exchange regime can collapse: (i) a harmful shock may change the environment so much so that the maintenance of the fixed exchange regime is not possible, and (ii) a predictable cumulating sequence of small events culminates in the predictable collapse of the system. Here, policymakers weigh the cost and benefits of defending the currency and are willing to give up an exchange rate target if the cost-benefit analysis is not feasible. The doubts regarding government’s decision to maintain or not maintain the target can lead to the existence of multiple equilibria, and a speculative currency attack can take place and succeed even though current policy is not consistent with the exchange rate commitment.

The third generation models (3G) emphasize the balance-sheet effects associated with devaluations.  Banks and firms in emerging market countries (i) have explicit currency mismatches on their balance sheet because they borrow in foreign currency and lend in local currency; (ii) face credit risk because their income is related to the production of non-traded goods whose price, evaluated in foreign currency, fall after devaluations, and (iii) are also exposed to liquidity shock because they finance long-term projects with short-term borrowing. Different 3G explore various mechanism through which balance-sheet exposures may lead to a currency and banking crisis.