Financial Instability under Floating Exchange Rates

Damien Besancenot and Radu Vranceanu

No DR 03011, ESSEC Working Papers from ESSEC Research Center, ESSEC Business School

Abstract: At the end of the nineties, many developing countries featured an open capital market and relied heavily on dollar-debt financing of their economy. This paper analyses whether, in this context, clean floating can be a sustainable policy choice. The model is cast as a game between successive generations of investors who decide whether they buy or not the debt of a representative firm. The exchange rate is subject to random shocks, which makes uncertain the private sector’s solvency. We show that a small risk of insolvency would bring about a much larger risk of illiquidity. A rational expectation equilibrium without default can be put forward only in the highly improbable case when the currency is extremely overvalued. The case against flexible exchange rates may be stronger than usually thought.

Keywords: Floating; Rational Expectations; Financial Crises; Developing Countries (search for similar items in EconPapers)
JEL-codes: F30 G15 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2003-03
New Economics Papers: this item is included in nep-ifn, nep-mfd and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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