Financial Fragility, Exchange-Rate Regimes, and Sudden Stops in a Small Open Economy

Year 2012, Volume: 1 Issue: 3, 25 - 54, 01.09.2012

Wen-yao Grace Wang Paula Hernandez-verme Raymond A. K. Cox

Abstract

We model a typical Asian economy in crisis using a dynamic general equilibrium technique and establishing exchange rates from nontrivial fiat currency demands. Sudden stops/bank panics are possible and are essential for evaluating the merits of alternative exchange-rate regimes. Strategic complementarities contribute to the severe indeterminacy of a continuum of equilibria. Social welfare and the scope of equilibria are also associated with the underlying policy regime and the built-in Sequential Checking Mechanism, including liquidity, solvency, and incentive-compatibility constraints in the model. Combining domestic and foreign reserve requirements promotes stability under a floating exchange-rate regime; however, this increases the scope for panic equilibria under both floating and fixed regimes. While backing the money supply reduces financial fragility under both systems, it only acts as a stabilizer in a fixed regime.

Keywords

Sudden stops, exchange-rate regimes, multiple reserve requirements

Thanks

We thank the constructive comments provided by three anonymous referees. We owe special thanks to Leonardo Auerrnheimer, David Bessler, Li Gan, and Dennis Jansen for their helpful comments and suggestions on previous versions of this paper.

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