Working Paper: NBER ID: w7143
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. 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: currency crises; banking crises; government guarantees; exchange rate risk
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 (E32) |
| economic boom (E32) | increased banking fragility (F65) |
| increased banking fragility (F65) | currency devaluation (F31) |
| currency devaluation (F31) | bankruptcy of banks (G33) |
| bankruptcy of banks (G33) | rise in interest rates (E43) |
| rise in interest rates (E43) | decline in output (E23) |
| government guarantees (H81) | economic boom (E32) |
| government guarantees (H81) | increased banking fragility (F65) |
| government guarantees (H81) | currency devaluation (F31) |
| government guarantees (H81) | bankruptcy of banks (G33) |
| government guarantees (H81) | rise in interest rates (E43) |
| government guarantees (H81) | decline in output (E23) |