erc/metu
INTERNATIONAL CONFERENCE IN ECONOMICS  IV
September 13-16, 2000, Ankara

Exchange Rate Regimes, Capital Flows, and Twin Crises

Refet S. Gürkaynak (Princeton University, USA)

Abstract  

Recent financial crises in East Asian countries, Mexico, Turkey, and many other developing countries have highlighted the relationship between the health of the financial system and currency crises. In this paper I model a small open economy with shallow financial resources but higher expected return to capital compared to the world interest rate. Banks intermediate between domestic households and firms, and international lenders and firms in a costly-state-verification environment. Net worth of the banks is the driving variable of the model. Capital flows increase the speed of net worth accumulation compared to a closed economy. Exchange rate policies that lead to real appreciations increase capital flows, and hence net worth accumulation, but also lead to possible currency crises. The negative effect of currency crises is smaller in economies with shallower financial systems. The paper shows how currency and banking crises can trigger and amplify each other.

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