Contractionary Currency Crashes in Developing Countries
Jeffrey A. Frankel
To update a famous old statistic: a political leader in a developing country is almost twice as likely
to lose office in the 6 months following a currency crash as otherwise. This difference, which is
highly significant statistically, holds regardless 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 ten
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. Passthrough 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.
In order to set up a list of libraries that you have access to,
you must first login
or sign up.
Then set up a personal list of libraries from your profile page by
clicking on your user name at the top right of any screen.