Question

Some remedies and preventive measures have been put forth to slow or forestall currency crises, such as capital controls and intermediate regimes (i.e., fixed or floating exchange rates). Discuss these measures and comment on whether they would be effective. Explain why or why not.

Answer 1

A currency crisis is a situation in which serious doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate. The crisis is often accompanied by a speculative attack in the foreign exchange market. The primary cause of currency crises in the past has been a central bank's failure to maintain a fixed rate peg to a floating rate foreign currency.

There are many possible solutions to a currency crisis, including many preventative measures that can be taken to prevent a crisis from ever occurring.

The best solution to a currency crisis is avoiding them in the first place with preventative measures. Floating exchange rates tend to avoid currency crises by ensuring that the market is always setting the price, as opposed to fixed exchange rates where central banks must fight the market. For example, Britain's fight against George Soros required the central bank to spend billions to defend its currency against speculators, which proved to be impossible to maintain.

Central banks should also avoid monetary policies that involve trading against the market unless it's necessary to prevent a broader crisis.

Capital controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation's government can use to regulate flows from capital markets into and out of the country's capital account.Types of capital control include exchange controls that prevent or limit the buying and selling of a national currency at the market rate, caps on the allowed volume for the international sale or purchase of various financial assets, transaction taxes such as the proposed Tobin tax on currency exchanges, minimum stay requirements, requirements for mandatory approval, or even limits on the amount of money a private citizen is allowed to remove from the country. There have been several shifts of opinion on whether capital controls are beneficial and in what circumstances they should be used.