Financial fragility and the exchange rate regime

Roberto Chang and Andres Velasco

No 97-16, FRB Atlanta Working Paper from Federal Reserve Bank of Atlanta

Abstract: We study financial fragility, exchange rate crises, and monetary policy in an open economy version of a Diamond-Dybvig model. The banking system, the exchange rate regime, and central bank credit policy are seen as parts of a mechanism intended to maximize social welfare; if the mechanism fails, banking crises and speculative attacks become possible. We compare currency boards, fixed rates, and flexible rates with and without a lender of last resort. A currency board cannot implement a socially optimal allocation; in addition, bank runs are possible under a currency board. A fixed exchange rate system may implement the social optimum but is more prone to bank runs and exchange rate crises than a currency board. A flexible rate system implements the social optimum and eliminates runs, provided the exchange rate and central bank lending policies are appropriately designed.

Keywords: Banks and banking, Central; Financial crises; Financial institutions; Foreign exchange rates (search for similar items in EconPapers)
Date: 1997
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Citations: View citations in EconPapers (9)

Published in Journal of Economic Theory, May 2000

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Related works:
Journal Article: Financial Fragility and the Exchange Rate Regime (2000)
Working Paper: Financial Fragility and the Exchange Rate Regime (1998)
Working Paper: Financial Fragility and the Exchange Rate Regime (1998)
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