Exchange Rate Stability and Financial Stability

In this paper I consider the connections between the exchange rate and the financial system, focusing on the implications of international monetary arrangements for the stability of the banking system. I ask questions like the following. Under what conditions can a currency peg jeopardize the stability of the banking system? Can adopting a peg set in motion processes that weaken the banks, themselves the linchpin of the financial system? Once the banking system weakens, how serious an obstacle is the currency peg to lender-of-last-resort intervention? While this review of the historical record shows that there is no simple mapping between exchange rate stability and financial stability, it confirms that the textbook insight about the origin of disturbances and the advantages of fixed and floating rates remains the obvious place to start. When disturbances are imported, a flexible rate provides useful insulation; when they are domestic, exchange rate stability allows them to be shared with the rest of the world and disciplines domestic policymakers. This simple logic applies directly to the stability of the banking system. When disturbances to the banking system originate abroad, exchange rate flexibility can help to insulate the banks from shocks to their funding and investments. It gives the authorities the opportunity to act as lenders of last resort. The Great Depression provides perhaps the clearest illustration: in the 1930s most countries experienced the contraction of credit and collapse of activity as an imported shock, and those which allowed their exchange rates to adjust, decoupling domestic monetary and financial conditions from those abroad, were best able to avert banking panics, and to engage in lenderof- last-resort operations. Conversely, when macroeconomic and financial shocks jeopardizing the stability of the banking system are home grown, pegging the exchange rate allows idiosyncratic disturbances to spill out into the rest of the world and imposes discipline on domestic policymakers. Argentina in the 1990s illustrates the point: by adopting a rigid currency peg it has prevented domestic policymakers from succumbing to the monetary and fiscal excesses that long destabilized its banking system.

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Publication Type:
Working or Discussion Paper
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JEL Codes:
Fl; O2
Series Statement:
Working Paper

 Record created 2017-04-01, last modified 2017-04-26

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