Financial Fragility and the Exchange Rate Regime

Roberto Chang and Andres Velasco
Federal Reserve Bank of Atlanta
Working Paper 97-16
November 1997

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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

The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

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,, or Andres Velasco, Department of Economics, New York University, 269 Mercer Street, New York, New York 10003, 212/998-8958,

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