Exercise 8 In general, currency crises are associated with severe falls in economic activity. However, a good part of the first- and second-generation currency crisis models does not explicitly model the factors that could explain the recession. Consider a small, open economy with a fixed exchange rate regime and in which investors depend both on the real interest rate, r, as well as a variable, θ, which can be interpreted as a variable associated with the risk of a currency crisis, according to the perception of the agents. Therefore, the investment function can be written as I 5 gðr; θÞ 5 I0 1 g1r 2 g2θ;

where g1 and g2 are constant positive parameters. For the sake of simplification, assume that variable θ possesses binary behavior, as following described:

θ 5 0; if ΔS # 0

[c ðΔSÞ

2

; if ΔS $ 0



Chapter 9 • Currency Crises 261 where S represents the nominal exchange rate and [c . 0 measures the sensitivity of [ in relation to changes in S.

a. Explain why the perception of a currency crisis negatively affects investments.

b. Based on what has been seen in this chapter, especially in what refers to the asset balance sheet currency mismatch of financial institutions, explain how a proxy could be created for variable θ.

c. Assume that the nominal exchange rate goes from S1 to S2, with S2 . S1. Calculate the change in investments in this case.

Consider that the aggregate demand in this economy is given by Y 5 C 1 I 1 G 1 TB, and the trade balance in nominal terms is given by TB 5 X 2 M 5 PT 2 SPT, where T represents the amount imported and T the amount exported. Notice that, according to the trade balance equation, exchange rate depreciation impacts import values, making them more expensive. This effect can be interpreted as a short-term response to changes in the exchange rate, while the decisions to import and export have not yet reacted to the new relative price. Equilibrium in the money market is represented by function MS P 5 κY 2 λi.

d. What is the effect of the exchange rate depreciation described in item

(c) on the aggregate demand? Explain your answer in a quantitative and intuitive form, based on the elements of economic theory. Illustrate the possible cases on a graph.

e. How could you relate the answer given in the previous item with the third-generation currency crisis models, especially in referring to the output dynamics?