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8
Sep
2014

ASIAN CURRENCY CRISIS: Optimal Monetary Policy 2

To finance the increase in the present value of the deficit it must be the case that:
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Since this is feasible, the proposed policy supports the optimal equilibrium allocation Click Here.

One important caveat to the preceding discussion is that it abstracts from nominal rigidities in prices and wages as well as from non-indexed domestic debt and unhedged loans denominated in foreign currency. These aspects can clearly affect optimal monetary policy and the optimal time to abandon fixed exchange rates. The key point of the preceding discussion is to emphasize that there are clear costs to delaying the adjustment of monetary policy. In our model, the cost is the distortion of consumption decisions induced by the fact that lower inflation now is purchased at the price of higher inflation in the future. The more a government borrows to delay a speculative attack, i.e. the higher is Ф, the higher are these costs. In this sense, the ability to borrow from abroad to delay a speculative attack actually reduces welfare.

This section presents evidence to assess the empirical plausibility of our interpretation of the recent Southeast Asian currency crisis. Specifically, we offer evidence in support of three key assumptions in our model: (i) foreign reserves do not play a special role in the timing of the attack, (ii) large losses in the banking sector were associated with increases in governments’ prospective deficits, and (iii) the public knew that banks were in trouble before the exchange rate crises.

Some Background Information

Table 5:
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Figure 4 plots exchange rates of various Southeast Asian countries from July 1995 through May 1998. To provide a frame of reference, vertical lines axe drawn at what we refer to as the crisis dates. These correspond to the first instance in which there were historically large devaluations or depreciations of the currency in question. Table 5 presents the cumulative depreciation rates of various Southeast Asian currencies from the crisis dates to May 1998. It is evident that the experience of the crisis countries was very different from that of the non-crisis countries (Hong Kong, Singapore and Taiwan).

As further background, Table 6 presents the annual growth rate of real GDP, the official CPI inflation rates and the fiscal surpluses for the Southeast Asian countries, Japan and the U.S, over the period 1995 – 1997. Note that there are no dramatic differences between the crisis and non-crisis countries. The crises certainly could not have been predicted on the basis of large and/or growing precrisis fiscal deficits in the crisis countries. We refer the reader to Corsetti, Pesenti and Roubini (1998) for a more comprehensive survey of the pre crisis situation in Southeast Asia.

To finance the increase in the present value of the deficit it must be the case that: Since this is feasible, the proposed policy supports the optimal equilibrium allocation Click Here. One important caveat to the preceding discussion is that it abstracts from nominal rigidities in prices and wages as well as from non-indexed domestic debt and unhedged loans denominated in foreign currency. These aspects can clearly affect optimal monetary policy and the optimal time to abandon fixed exchange rates. The key point of the preceding discussion is to emphasize that there are clear costs to delaying the adjustment of monetary policy. In our model, the cost is the distortion of consumption decisions induced by the fact that lower inflation

About The Author

Kevin J. Brandon

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