An African country has a policy of fixing the exchange rate value of its currency to...

An African country has a policy of fixing the exchange rate value of its currency to the U.S. dollar. Banks in the country have a business model in which the banks pay competitive interest rates to attract U.S. dollar deposits, and the banks then use these funds to make higher-interest loans denominated in the local currency. How likely would an unexpected devaluation of the local currency be to lead to banking crisis? Why?

Expert Solution

A devaluation of local currency reduces the value of the local currency against a foreign currency (in this case, USD). Now, while the money that the bank has to pay back to the depositers in terms of USD does not change (when they withdraw deposits and since deposits are liablities to banks), the amount that the banks have to pay back in terms of the local currency increases because more local money is needed to amount to the same amount of USD (due to devaluation).

The repayments of the loans denominated in local currency is at the expected level in terms of local currency. However, if calculated in terms of USD, the repayment value is reduced due to the reduced value of the local currency.

Therefore, the liabilities of the banks in terms of local currency increases, while its assets (the loans denominated in local currency) remain the same in terms of local currency. Or in terms of USD, while the withdrawal value (liabilities) remain the same, the asset value (loans in local currency) decreases due to devaluation. Therefore, there is a significant asset-liability mismatch leading to a banking crisis.

Rahul Sunny answered 2 years ago

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

21. If a small country fixes its exchange rate against a large country’s currency, and the...

21. If a small country fixes its exchange rate against a large country’s currency, and the small country initially has a higher inflation rate than the large country, the two inflation rates will be equalized because A. the higher inflation in the small country appreciates its real exchange rate, reducing net exports and output, and reducing the inflation rate to the same rate as in the large country. B. the higher inflation in the small country depreciates its real exchange...

A country has had a steady value for its floating exchange rate (stated inversely as the...

A country has had a steady value for its floating exchange rate (stated inversely as the domestic currency price of foreign currency) for a number of years. The country now tightens up on (reduces) its money supply dramatically. The country’s product price level is not immediately affected, but the price level gradually becomes lower (relative to what it otherwise would have been) during the next several years. 1. Why might the market exchange rate change a lot as this monetary...

6. Suppose a country wants to fix the exchange rate of its domestic currency higher than...

6. Suppose a country wants to fix the exchange rate of its domestic currency higher than what markets alone would bring about. (a) Suppose the central bank officially sets the higher-than-market exchange rate for the domestic currency, but otherwise undertakes no action. Which would result, a surplus of the currency or a shortage of the currency? (b) Suppose the central bank does undertake an action to achieve its desired fixed exchange rate. Which would the central bank do, buy the...

Assume the country of Sluban ties its currency (the slu) to the dollar and the exchange...

Assume the country of Sluban ties its currency (the slu) to the dollar and the exchange rate will remain fixed. Sluban has frequent trade with countries in the eurozone and the United States. All traded products can easily be produced by all the countries, and the demand for these products in any country is very sen- sitive to the price because consumers can shift to wherever the products are relatively cheap. Assume that the euro depreciates substantially against the dollar...

Suppose that country A pegs its currency to country B’s currency, and A has excessively high...

Suppose that country A pegs its currency to country B’s currency, and A has excessively high inflation. Country B is only likely to help A if: a. both are members of the International Monetary Fund. b. country B has a free trade agreement with country A. c. country B’s output is above its preferred level. d. country B does not trade at all with country A. e. country B’s output is below its preferred level.

What are the advantages of fixing or floating and exchange rate? What is the “unholy trinity”...

What are the advantages of fixing or floating and exchange rate? What is the “unholy trinity” of the Mundell-Fleming theory and how does it relate to the choice of exchange rate regime? How does the Mundell-Fleming theory relate to the contemporary era of the world economy and the Euro in particular?

Suppose a country has fixed exchange rate and no capital controls. The country has kept the...

Suppose a country has fixed exchange rate and no capital controls. The country has kept the value of its currency below its market level. Now, due to a political crisis, projections for economic growth in coming years are revised sharply downwards. As a result of new projections, savers wish to purchase financial assets in other countries.(e)Will the country be able to maintain the exchange rate? (f)Capital flows can cause problems for exchange rate stability. So, why do most countries allow...

The exchange rate of a currency is the price paid in one country's currency for the...

The exchange rate of a currency is the price paid in one country's currency for the currency of another country. If a company in the United States sources parts from a company in Europe, dollars will need to be converted to euros to pay for the parts. This need to convert currency introduces uncertainty as to the actual cost of the parts, since the exchange rate at the time the price is quoted may be different from the rate when...

Study the exchange rate policy of one country (or one group of countries) of your choice...

Study the exchange rate policy of one country (or one group of countries) of your choice and write a short report on what they did (fixed/pegged/floating/other interventions…) and their possible motivations (i.e. costs/benefits). The report should be 1-2 pages long with normal text size and line spacing.

Question