Question

1. Describe the stages of a currency crisis when a country has a fixed exchange rate.

Answer 1

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Abstract

Since the early 1990s, there have been several instances of currency crises. These are a sudden and drastic devaluation in a nation's currency matched by volatile markets and a lack of faith in the nation's economy. A currency crisis is sometimes predictable and is often sudden. It may be precipitated by governments, investors, central banks, or any combination of actors. But the result is always the same: The negative outlook causes wide-scale economic damage and a loss of capital. In this article, we explore the historical drivers of currency crises and uncover their causes.

Stages of Currency Crisis

• A currency crisis involves the sudden and steep decline in the value of a nation's currency, which causes negative ripple effects throughout the economy.
• Unlike a currency devaluation as part of a trade war, a currency crisis is not a purposeful event and is to be avoided.
• Central banks and governments can intervene to help stabilize a currency by selling off reserves of foreign currency or gold, or by intervening in the forex markets.

A currency crisis is brought on by a sharp decline in the value of a country's currency. This decline in value, in turn, negatively affects an economy by creating instabilities in exchange rates, meaning one unit of a certain currency no longer buys as much as it used to in another currency. To simplify the matter, we can say that, from a historical perspective, crises have developed when investor expectations cause significant shifts in the value of currencies.

Currency crisis predictions involve the analysis of a diverse and complex set of variables. There are a couple of common factors linking recent crises:

1. The countries borrowed heavily (current account deficits)
2. Currency values increased rapidly
3. Uncertainty over the government's actions unsettled investors
4. As fixed exchange rates became exceedingly difficult to maintain, many Southeast Asian currencies dropped in value.
5. Southeast Asian economies saw a rapid increase in privately-held debt, which was bolstered in several countries by overinflated asset values. Defaults increased as foreign capital inflows dropped off.
6. Foreign investment may have been at least partially speculative, and investors may not have been paying close enough attention to the risks involved.

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