Working Paper: CEPR ID: DP2171
Authors: Craig Burnside; Martin Eichenbaum; Sergio Rebelo
Abstract: Currency crises that coincide with banking crises tend to share four elements. First, governments provide guarantees to domestic and foreign bank creditors. Second, banks do not hedge their exchange rate risk. Third, there is a lending boom before the crises. Finally, when the currency/banking collapse occurs interest rates rise and there is a persistent decline in output. This paper proposes an explanation for these regularities. We show that government guarantees lower interest rates, and generate an economic boom. But they also lead to a more fragile banking system: banks choose not to hedge exchange rate risk. When the fixed exchange rate is abandoned in favor of a crawling peg banks go bankrupt, the domestic interest rate rises, real wages fall and output declines.
Keywords: fixed exchange rate regimes; hedging; government guarantees
JEL Codes: F31; F41; G15; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government guarantees (H81) | Lower interest rates (E43) |
| Lower interest rates (E43) | Economic boom (N12) |
| Government guarantees (H81) | Increased bank exposure to exchange rate risk (F31) |
| Abandonment of fixed exchange rate (F31) | Bank bankruptcies (G33) |
| Government guarantees (H81) | Economic fragility (F65) |
| Economic fragility (F65) | Decline in output, employment, and real wages (F66) |