Working Paper

Financial fragility and the exchange rate regime

Abstract: 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.

Keywords: Banks and banking, Central; Financial crises; Financial institutions; Foreign exchange rates;

Status: Published in Journal of Economic Theory, May 2000

Bibliographic Information

Provider: Federal Reserve Bank of Atlanta

Part of Series: FRB Atlanta Working Paper

Publication Date: 1997

Number: 97-16