Currency Crises and Monetary Policy: A Study on Advanced and Emerging Economies

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Currency Crises and Monetary PolicyA Study on
Advanced and Emerging Economies

• Sylvester Eijffinger and Bilge Karatas
• Tilburg University
• CIGI, VERC and University of Tasmania Conference
• October 04, 2011

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Outline

• Introduction
• Theoretical Models in Currency Crises
• Monetary Policy Response to Currency
• Empirical Analysis
• Methodology and Data
• Pooled OLS Results
• System GMM Results
• Conclusion

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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)

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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.

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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.

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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.

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Empirical Analysis Crisis Periods
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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

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Empirical Analysis Episode Specific 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

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Empirical Analysis Pooled OLS Results
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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
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Empirical Analysis System GMM Estimation Results
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• 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

Depreciation
Depreciation
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Conclusions

• Tight monetary policys 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.

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Discussion