Question

If many analysts agree that a strong macro-economy is necessary for currency stability but not sufficient, what factors might account for the fact that, countries with sound fundamentals or macroeconomic policies may not be immune from currency crises and that government may have to regulate the market rather than leave it to work on it own?

Answer 1

A currency crises occurs following a decline in the value of a country's currency. The crises has an adverse impact on an economy, as it creates instabilities in exchange rates.

Unstable exchange rates cause traders and investors to lose confidence in the Central Bank's ability to maintain enough capital reserves to preserve the currency's value, which in turn leads them yo remove their money from the economy, when the traders remove their money and invest in some foreign currency it further deteriorates the exchange rate.

This in turn, makes the capital spending of the economy difficult, the central banks to control this must raise interest rates to counterbalance the downward pressure.

To counter the currency crises the government needs to intervene through the central bank, it can start by reducing money printing to the minimum.

But with this the government should not fix the exchange rate, rather it should leave it to the free market, to maintain the floating exchange rate.

The floating exchange rate will ensure that the free market sets up the exchange rate rather than the government fixing it up.