Currency Crises and Monetary Policy:A Study on Advanced and Emerging Economies Sylvester Eijffinger and Bilge Karatas Tilburg University CIGI, VERC and University of Tasmania Conference October 04, 2011
Outline • Introduction • Theoretical Models in Currency Crises • Monetary Policy Response to Currency • Empirical Analysis • Methodology and Data • Pooled OLS Results • System GMM Results • Conclusion
Introduction: Currency Crisis “...an episode in which the exchange rate depreciates substantially during a short period of time” (Burnside et al., 2007) Theoretical Models in Crisis Explanation: First Generation Models Balance Sheet Imbalances of the Government (Krugman, 1979) Second Generation Models Self-fulfilling Expectations (Obstfeld, 1994) Third Generation Models Balance Sheet Imbalances of the Private Sector (Krugman, 1999 & Chang and Velasco, 1998)
Introduction: Monetary Policy Response • Conventional Wisdom: The behavior of exchange rate is explained with asset market conditions. Tighter monetary policy followed today leads to a stronger currency today: IS THAT THE CASE DURING CRISIS TIMES? • Empirical Studies: • Goldfajn & Gupta (2003): Tight monetary policy facilitates the reversal of the real exchange rate. In contrast, in periods of twin crises the effectiveness of tight monetary policy decreases. • Kraay (2003): There is little evidence that monetary policy has any positive or negative effect on exchange rate. • Eijffinger & Goderis (2008): Focusing on the third generation vulnerabilities the study concludes that tight monetary policy depreciates the exchange rates following currency crisis.
Introduction: Research Question and Motivation • Research Question: “Do Emerging and Advanced Economies Need Different Monetary Policies Following a Currency Crisis?” • Various economic vulnerabilities preceding and following the currency crisis in emerging and advanced economies motivated a separate analysis for these groups of economies.
Empirical Analysis: Methodology and Data Years: 1986 – 2009 24 Economies – 9 Advanced and 15 Emerging. Crisis Period Identification (Eijffinger and Goderis, 2008): 35 crisis periods Starting month of the currency crisis is the month with the large depreciation of the nominal exchange rates following the period of moderately stable exchange rates. Ending month of the currency crisis is the first month after the start in which speculative pressures have substantially diminished compared to earlier peaks.
Empirical Analysis :Methodology and Data : Change in the Nominal Exchange Rates : Change in Monetary Policy: Money Market Interest Rates : Episode-Specific Fundamentals :Interaction terms : Monetary Policy X Fundamentals
From Eijffinger and Goderis (2008) Deviation of the Real Per-Capita GDP Real Exchange Rate Overvaluation Corporate Short-term Debt to Total Assets Institutional Quality Capital Account Openness From Kaminsky (2006) Fiscal Position Stock Prices Short-term External Debt Current Account Position Central Bank Transparency Empirical Analysis: Episode Specific Fundamentals
Emerging Economies Monetary Policy: Ambiguous Overvaluation Low Inst. Quality Fall in Stock Prices Low CB Transparency MP X Debt to Assets MP X KA Openness MP X Fiscal Deficit MP X Stock Prices MP X CB Transparency Advanced Economies Monetary Policy: Ambiguous CA Deficit MP X CA Deficit MP X Fiscal Deficit MP X Stock Prices Depreciation Depreciation
Depreciation Emerging Economies Monetary Policy: Ambiguous Fall in Stock Prices MP X Debt to Assets MP X Stock Prices MP X CB Trans. Advanced Economies Monetary Policy: Ambiguous Deviation GDP Growth CA Deficit Overvaluation Low Inst. Quality MP X CA Deficit MP X Fiscal Deficit MP X Stock Prices Depreciation
Conclusions Tight monetary policy’s ineffectiveness in exchange rate stabilization is an emerging economy problem: Financial and corporate sector problems + Tight policy = Depreciation of exchange rates. Transparency of central banking has a crucial role in policy implementation. Advanced Economies: Excluding 2008 financial crisis, tight policy stabilizes exchange rates.