RDP 2002-08: Currency Crises and Macroeconomic Performance 1. Introduction

Over the past decade or so, events in east Asia, eastern Europe and Latin America have invigorated research into sudden currency depreciations. Much of the recent interest in depreciations has collected around their proximate causes and their short-term policy implications. By contrast, the longer-term effects of sudden depreciations have been a relatively minor theme in the literature. This paper addresses these longer-term effects. It presents evidence on the effects of currency crises in a substantial number of cases over a 34-year period ending in 1998, and it offers a simple theoretical framework for exploring the dynamic response of an economy to a sudden depreciation of its currency.

The data show that sudden nominal depreciations occasionally stimulate an economy, but more frequently they lead to falls in output. The adverse effects of a currency crisis on output turn out to be most pronounced in countries which simultaneously have banking crises; which have a greater trade dependency; whose exchange rates are naturally volatile; and in countries which are poor.

The data also identify some of the effects of currency crises on inflation. Firm prior expectations of price behaviour are difficult to form. On the one hand, sudden depreciations add directly to the cost of imports. But this effect could be at least partially, and perhaps more than fully, offset when the depreciation coincides with falling aggregate demand.

For the countries and crises in our sample, the offset turns out to be partial. The average inflation rate of most countries is higher in the two years after a crisis than it was in the two years preceding. But the increase is not always very great, and in a fair proportion of cases – about 30 per cent – average inflation actually fell after a crisis.

The formal theoretical exercise in the paper rationalises some of these features of sudden depreciations, describing the propagation process with a simple monetary model, and identifying some of the factors which distinguish benign from malign depreciations. The condition of the banking system and the exposure of the economy to imported inflation are highlighted in the analysis.

The model is then used to devise monetary policy rules for crises. It shows that a monetary authority which seeks price and output stability is most likely to tighten policy in response to a currency crisis when the crisis has not disrupted the domestic financial system. In the event of twin banking and currency crises, the monetary authority might have to ease policy, unless there is substantial import price inflation. The optimal policy is subject to developments in the banking system because a twin crisis will tend to produce a much larger rise in the domestic interest rate than would a simple increase in the world interest rate. In these circumstances, the dampening effects of the higher interest rates on activity can overwhelm the stimulus from a depreciated exchange rate.

The next section of the paper presents data on some of the currency crises that have occurred around the world over a 34-year period. Section 3 presents the formal modelling and Section 4 concludes with a brief summary of the main results.