Working Paper: NBER ID: w7418
Authors: Barry Eichengreen; Ricardo Hausmann
Abstract: In this paper we analyze three views of the relationship between the exchange rate and financial fragility: (1) the moral hazard hypothesis, according to which pegged exchange rates offer implicit insurance against exchange risk and thereby encourage reckless borrowing and lending; (2) the original sin hypothesis, which emphasizes an incompleteness in financial markets which prevents the domestic currency from being used to borrow abroad or to borrow long term even domestically; and (3) the commitment problem hypothesis, which sees financial crises as resulting from neither moral hazard nor original sin but from the weakness of the institutions that address commitment problems. We examine the evidence on these hypotheses and draw out their implications for exchange-rate policy in emerging markets.
Keywords: exchange rates; financial fragility; moral hazard; original sin; commitment problems
JEL Codes: F31; F33; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government policies (H59) | Investor behavior (G41) |
| Implicit guarantees from governments (H81) | Excessive risk-taking by investors (G41) |
| Excessive risk-taking by investors (G41) | Financial instability (F65) |
| Financial market incompleteness (D52) | Currency and maturity mismatches (F31) |
| Currency and maturity mismatches (F31) | Financial fragility (F65) |
| Institutional strength (D02) | Financial market stability (E44) |
| Weak institutional frameworks (O17) | Volatile financial outcomes (G19) |