Twin Banking and Currency Crises and Monetary Policy

Ryota Nakatani

Open Economies Review, 2016, vol. 27, issue 4, No 6, 747-767

Abstract: Abstract Currency crises are found to be strongly associated with banking crises. This paper constructs a twin banking and currency crisis model by introducing the banking sector into the currency crisis model and examining the case in which the exchange rate risk is located in the banking system. The model shows that an unanticipated shock caused by the shift of investors’ expectations and/or a negative productivity shock can trigger a twin banking and currency crisis. To achieve both financial stability and economic stability, the central bank uses multiple monetary policy instruments. In contrast to the conventional policy recommendation in response to a currency crisis, i.e., interest rate hike, we find that when the exchange rate risk is located in the banking sector, the monetary policy option to prevent a twin crisis is to lower the policy interest rate and the reserve requirement ratio and raise the interest rate on reserves. Our results show that the location of the exchange rate risk matters for the choice of an appropriate monetary policy response during a crisis.

Keywords: Currency crisis; Banking crisis; Twin crisis; Monetary policy; Reserve requirement ratio; Interest rate on reserves (search for similar items in EconPapers)
JEL-codes: E4 E5 F3 F41 G15 G21 (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (23)

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DOI: 10.1007/s11079-016-9391-2

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