Currency Crises and Real Exchange Rate Depreciation

Roni Frish ()
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Roni Frish: Bank of Israel

No 2016.01, Bank of Israel Working Papers from Bank of Israel

Abstract: This research examines episodes of sharp depreciation in the real exchange rate that occurred in 1980–2009, with a special attention on prolonged depreciations that did not soon wind down. Previous research focused on sharp nominal depreciations1 (such as Kaminsky et al. (1988), Frankel and Rose (1996), Eichengreen et al. (2002) and Bussiere (2013)), and found a large number of variables that could signal such an occurrence. A sharp and prolonged real depreciation is a rarer occurrence, reflecting a sharp and prolonged decline in the relative price of domestically produced goods relative to goods produced abroad, and the factors behind it have barely been studied in the empirical literature. An empirical examination of the real effective exchange rate (REER, which is calculated by the IMF) indicates that the most notable variable that preceded a sharp and prolonged real depreciation are a large and prolonged Current Account deficit. High inflation and low foreign currency reserves increase the chance of a sharp and transitory nominal depreciation, but were not found to have an effect on the probability of a sharp and prolonged real depreciation. The phenomenon of sharp depreciations is related to the low elasticity of exports and imports (the Current Account) with regard to the real exchange rate: a reduction in the Current Account deficit requires a large and prolonged real depreciation. (At times even such a depreciation is not enough to reduce the deficit because Marshall–Lerner conditions do not fulfil.2)

Pages: 48 pages
Date: 2016-01
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