Of what does the policy trilemma consist?
Fixed exchange rate
Monetary policy independence
International capital mobility
How to prevent financial crisis?
- Better bank regulation, supervision and risk management
- Captial controls;
To prevent excessive capital inflows/overborrowing/overlending. To discourage short-term borrowing and to limit contagion to other countries
What is the free rider problem?
A situation where those who benefit from a common resource do not pay for or, which results in an underprovision of this good or service
What is debt restructuring?
Changes in terms of conditions of existing debt
- rescheduling: pushing repayments schedule to the future
- reduction: lowering the amount of outstanding debt
Downside = free rider problem
What is moral hazard
Moral hazard is a situation in which one party gets involved in a risky activity knowing that it is protected against the risk and the other party will incur the cost
What is a rescue package?
Additional low-interest loans to:
- compensate for the lack of private lending
- restore investor confidence by replenishing foreign reserves and signal international support
- limit contagion to other countries
- enforce policy changes
Reasons for contagion (2 more)
Because of overreaction by foreign lenders and selffulfilling expectations
Or wake-up call
What is contagion?
Spread of a currency crisis to other countries because of economic links between countries
- other countries exporting similar products will lose competitiveness
- investors may be unable/unwilling to continue lending to other countries
Forces leading to currency crises
- Rise in foreign interest rate
- Private sector and banks take an excessive liabilies in foreign currency
- Taking on excessive short-term debt
- Running large current account deficits
- Weak banking system with inadequate supervision and regulation
- High inflation
- Global contagion
Reasons that investors may lose confidence in a currency?
- overlending/overborrowing:
risk of government defoult by debt accumulation.
overlending to private sector
once there is a risk of default, investors lose confidence
What does the DB do to counteract?
Raise interest rates to make domestic assets more attractive
Sell foreign reserve assets against local currency to increase demand
What is the reason for speculative attacks?
Investors have nothing to lose (one-way speculative gamble)
they are protected if devaluation happens
If not it’s only a tiny loss from forgoing foreign interest earnings
What is a currency crisis?
Serious doubt exist about whether a country’s CB has sufficient foreign exchange reserves to maintain fixed exchange rate.
Often accompanied by a speculative attack
Often culminates a sharp devaluation of the currency or a switch to flexible exchange rates leading to massive depreciation
