We study financial fragility, exchange rate crises, and monetary policy in an open economy version of a Diamond-Dybvig model. The banking system, the exchange rate regime, and central bank credit policy are seen as parts of a mechanism intended to maximize social welfare; if the mechanism fails, banking crises and speculative attacks become possible. We compare currency boards, fixed rates, and flexible rates with and without a lender of last resort. A currency board cannot implement a socially optimal allocation; in addition, bank runs are possible under a currency board. A fixed exchange rate system may implement the social optimum but is more prone to bank runs and exchange rate crises than a currency board. A flexible rate system implements the social optimum and eliminates runs, provided the exchange rate and central bank lending policies are appropriately designed.
JEL classification: F3, E5, G2
Key words: exchange rates, financial crises, central bank policy
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Please address questions regarding content to Roberto Chang, Research Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, NW, Atlanta, Georgia 30303-2713, 404/498-8057, firstname.lastname@example.org, or Andres Velasco, Department of Economics, New York University, 269 Mercer Street, New York, New York 10003, 212/998-8958, email@example.com.
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