Currency Crises and Monetary Policy: A Study on Advanced and Emerging Economies Sylvester Eijffinger and Bilge Karatas Tilburg University CIGI, VERC and University of Tasmania Conference October 04, 2011

Outline Introduction  Theoretical Models in Currency Crises  Monetary Policy Response to Currency Empirical Analysis  Methodology and Data  Pooled OLS Results  System GMM Results Conclusion

Introduction: Currency Crisis “...an episode in which the exchange rate depreciates substantially during a short period of time” (Burnside et al., 2007) Theoretical Models in Crisis Explanation:  First Generation Models Balance Sheet Imbalances of the Government (Krugman, 1979)  Second Generation Models Self-fulfilling Expectations (Obstfeld, 1994)  Third Generation Models Balance Sheet Imbalances of the Private Sector (Krugman, 1999 & Chang and Velasco, 1998)

Introduction: Monetary Policy Response Conventional Wisdom: The behavior of exchange rate is explained with asset market conditions. Tighter monetary policy followed today leads to a stronger currency today: IS THAT THE CASE DURING CRISIS TIMES? Empirical Studies:  Goldfajn & Gupta (2003): Tight monetary policy facilitates the reversal of the real exchange rate. In contrast, in periods of twin crises the effectiveness of tight monetary policy decreases.  Kraay (2003): There is little evidence that monetary policy has any positive or negative effect on exchange rate.  Eijffinger & Goderis (2008): Focusing on the third generation vulnerabilities the study concludes that tight monetary policy depreciates the exchange rates following currency crisis.

Introduction: Research Question and Motivation Research Question: “Do Emerging and Advanced Economies Need Different Monetary Policies Following a Currency Crisis?”  Various economic vulnerabilities preceding and following the currency crisis in emerging and advanced economies motivated a separate analysis for these groups of economies.

Empirical Analysis: Methodology and Data Years: 1986 – Economies – 9 Advanced and 15 Emerging. Crisis Period Identification (Eijffinger and Goderis, 2008): 35 crisis periods  Starting month of the currency crisis is the month with the large depreciation of the nominal exchange rates following the period of moderately stable exchange rates.  Ending month of the currency crisis is the first month after the start in which speculative pressures have substantially diminished compared to earlier peaks.

Empirical Analysis: Crisis Periods

Empirical Analysis : Methodology and Data : Change in the Nominal Exchange Rates : Change in Monetary Policy: Money Market Interest Rates : Episode-Specific Fundamentals :Interaction terms : Monetary Policy X Fundamentals

Empirical Analysis: Episode Specific Fundamentals From Eijffinger and Goderis (2008)  Deviation of the Real Per- Capita GDP  Real Exchange Rate Overvaluation  Corporate Short-term Debt to Total Assets  Institutional Quality  Capital Account Openness From Kaminsky (2006)  Fiscal Position  Stock Prices  Short-term External Debt Current Account Position Central Bank Transparency

Empirical Analysis: Pooled OLS Results

Emerging Economies Monetary Policy: Ambiguous Overvaluation Low Inst. Quality Fall in Stock Prices Low CB Transparency MP X Debt to Assets MP X KA Openness MP X Fiscal Deficit MP X Stock Prices MP X CB Transparency Advanced Economies Monetary Policy: Ambiguous CA Deficit MP X CA Deficit MP X Fiscal Deficit MP X Stock Prices Depreciation

Empirical Analysis : System GMM Estimation Results

Emerging Economies Monetary Policy: Ambiguous Fall in Stock Prices MP X Debt to Assets MP X Stock Prices MP X CB Trans. Advanced Economies Monetary Policy: Ambiguous Deviation GDP Growth CA Deficit Overvaluation Low Inst. Quality MP X CA Deficit MP X Fiscal Deficit MP X Stock Prices Depreciation

Conclusions Tight monetary policy’s ineffectiveness in exchange rate stabilization is an emerging economy problem: Financial and corporate sector problems + Tight policy = Depreciation of exchange rates. Transparency of central banking has a crucial role in policy implementation. Advanced Economies: Excluding 2008 financial crisis, tight policy stabilizes exchange rates.

Discussion