Question

1. Exchange rate crises

1. Explain how the central bank actually fixes the exchange rate.  What does this imply about the proximatecause of an exchange rate crisis with a fixed exchange rate? (2 pts)

2. Why do exchange rates crises tend to be more costly in emerging markets (i.e. poor/middle income countries) than in rich countries? (2 pts)

Answer 1

a. The central bank fixes the exchange rate by buying or selling currencies. Suppose, there is an appreciation in the value of the domestic currency, the central bank will, in that case, sell its reserves of the domestic currency to increase the supply of it in the forex market. Similarly, if the domestic currency depreciates, it will buy the domestic currency from the forex market to artificially increase the value of its currency in the market.

The proximate cause of an exchange rate crisis with a fixed exchange rate regime could be:

If the demand for the domestic currency in the forex market is low, the central bank artificially tries to increase the value of the currency by buying the currency and increasing its reserves of the domestic currency, but if the market demand is very low, it cannot keep on increasing its reserves indefinitely. Such a low demand will eventually result in devaluation.

b. Exchange rates crises tend to be more costly in emerging markets (i.e. poor/middle-income countries) than in rich countries because emerging countries generally peg their currency to a more stable one but this causes several issues for them. Some of them are listed below:

- Lack of control on their monetary policy as they are now more dependent on the other country.

- Transmission of shocks from the country whose currency the domestic currency is pegged with.

- Increase in financial fragility

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