[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

As speculators withdrew capital, the governments of the
affected countries faced difficult choices. One option was to
simply let their currencies depreciate. Unfortunately, in many
of these countries, domestic banks and firms had borrowed
heavily from foreign sources; a devaluation would make it
more difficult to repay these loans because it would raise the
domestic currency value that must be repaid. Devaluation
would therefore threaten the solvency of the banking sector
of these countries. The second option was to prevent a devaluation
by raising interest rates high enough to halt the capital
outflow. But doing so would severely constrict investment,
cut aggregate expenditures, and lead to output declines and
increases in unemployment.
The devastating economic consequences of financial crises
are clear from the declines in production in Latin America
during 1995 and 1996 and the declines in Asia in 1998 and 1999.
The chart illustrates the very high rates of economic growth
experienced in Asia throughout most of the 1990s. These
growth rates started falling in Asia in mid-1997, turning
negative in 1998.
and converts them into dollars, its revenues will fall short of the dollars it has already
paid to workers. It can insure itself by making a contract (with either a bank or a
dealer in the foreign exchange market) for the future delivery or sale of those euros
at a price agreed on today. It can thus avoid the risk of a change in the foreign
exchange rate. However, firms cannot easily buy or sell foreign exchange for delivery
two or three years into the future. Since many investment projects have a planning
horizon of years or even decades, investors are exposed to foreign exchange
risks against which they cannot insure themselves. But, as noted above, even firms
that do not buy or sell in foreign markets are exposed to risks from foreign exchange
rate fluctuations: American firms cannot buy insurance against the longer-term
risk that the American market will be flooded with cheap imports as a result of an
appreciation of the U.S. dollar. These risks are reduced if the exchange rate is fixed.
FLEXIBLE EXCHANGE RATE SYSTEMS
Today, while most governments do not peg the exchange rate at a particular value,
they do frequently intervene in the foreign exchange markets, buying and selling in
an attempt to reduce day-to-day variability in exchange rates. Rather than let the
exchange rate freely float as demand and supply vary, as would occur under a flexible
exchange rate system, governments take action. Economists sometimes refer to
this as a “dirty float” system.
Stabilizing the Exchange Rate Given the costs of exchange rate instability,
some have demanded that the government should actively try to stabilize the
exchange rate. Producers are particularly concerned that the real exchange rate
be stabilized, so that if inflation in the United States is higher than in foreign
countries, American exporters can still sell their goods abroad. As Figure 34.6
shows, there have been large movements in real exchange rates, just as there have
been in nominal exchange rates.
Any government program to stabilize the (real) exchange rate must meet three
requirements. First, the government must choose what the exchange rate should be.
Second, it must have a mechanism for keeping the real exchange rate at that value.
European Monetary Union, Frankfurt,
Germany
EXCHANGE RATE MANAGEMENT ∂ 771