International Business. Crises and Exchange rate

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Exchange rate adjustments often result from crises. The monetary agency's powers and scope are important determinates of the currency board's ability to weather crises. Consider five types of crises and how a currency board system handles them. First, a government's policies can create an economic crisis, particularly if it is running excessively expansionary policies that generate inflationary pressures in excess of those in the reserve currency country.


Even if there is no monetary agency, a government can create an inflation/debt crisis by excessive spending financed by domestic and international borrowing. Mutatis mutandis, the same considerations apply to a central bank that has the same degree of strictness as the currency board. (Betts, C. and Devereux, M, 2000)
Second, world securities markets might crash as, for example, in October 1987 or in the October 1989 mini-crash. Many countries' central banks expanded their stocks of high-powered money to provide liquidity to markets as investors fled from equities and corporate bonds and to high-quality assets such as U.S. T-bills and T-bonds. A currency board is ill-equipped to handle this type of crisis. At a time when it need to increase liquidity by expanding the domestic supply of money, a currency board is likely to have domestic currency presented for conversion to the reserve currency, as international investors who fled to U.S. government securities did in the 1987 and 1989 crises. This flight reduces the stock of domestic currency as well as that part of the country's international reserves that the currency board holds. ...
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