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Mundell-Fleming Lecture: Contractionary Currency Crashes in Developing Countries Jeffrey A. Frankel Full Text of this Article (PDF 588K) Abstract: To update a famous
old statistic: a political leader in a developing country is almost twice
as likely to lose office in the six months following a currency crash
as otherwise. This difference, which is highly significant statistically,
holds regardless of whether the devaluation takes place in the context
of an IMF program. Why are devaluations so costly? Many of the currency
crises of the last 10 years have been associated with output loss. Is
this, as alleged, because of excessive reliance on raising the interest
rate as a policy response? More likely it is because of contractionary
effects of devaluation. There are various possible contractionary effects
of devaluation, but it is appropriate that the balance sheet effect receives
the most emphasis. Pass-through from exchange rate changes to import prices
in developing countries is not the problem: this coefficient fell in the
1990s, as a look at some narrowly defined products shows. Rather, balance
sheets are the problem. How can countries mitigate the fall in output
resulting from the balance sheet effect in crises? In the shorter term,
adjusting promptly after inflows cease is better than procrastinating
by shifting to short-term dollar debt, which raises the costliness of
the devaluation when it finally comes. In the longer term, greater openness
to trade reduces vulnerability to both sudden stops and currency crashes. |
