Working Paper: CEPR ID: DP8224
Authors: Guillaume Plantin; Hyun Song Shin
Abstract: We ask when currency carry trades are associated with destabilizing dynamics in the foreign exchange market, and investigate the role of monetary policy rules in setting of such dynamics. In a model where the exchange rate has a long-term fundamental anchor, we find that carry trades can be stabilizing or destabilizing at shorter horizons, depending on the propensity of capital inflows to overheat the recipient economy. In the destabilizing case, we solve for a unique equilibrium that exhibits the classic pattern of the carry trade recipient currency appreciating for extended periods, punctuated by sharp falls.
Keywords: currency crises; emerging market bubbles; speculation
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| currency carry trades (F31) | destabilizing dynamics in the foreign exchange market (F31) |
| capital inflows (F21) | destabilizing dynamics in the foreign exchange market (F31) |
| monetary policy rules (E52) | stabilizing or destabilizing the economy (E63) |
| capital inflows (F21) | vicious cycle of increasing interest rates (E43) |
| vicious cycle of increasing interest rates (E43) | further exacerbating overheating (Y50) |
| weak fundamental anchor (Y80) | speculative dynamics deviating from long-term fundamentals (E32) |
| proactive monetary policy (E63) | stabilizing carry trades (F31) |
| reactive monetary policy (E63) | destabilizing carry trades (F31) |
| capital inflows + monetary policy interaction (F32) | extreme fluctuations in exchange rates (F31) |