The “elusive path” of currency stability that can lead to a crash
One of the roles of any modern central bank is to facilitate price stability. The currency exchange rate affects the price level - for some countries more than others. Policy makers may therefore be tempted to “support” a depreciating currency by increasing the interest rate differential (IRD), raising interest rates in order to do so. But although raising interest rates can initially increase the value of a currency, it has also other effects: it increases relative funding costs that can be transmitted into prices. Higher relative export prices are likely to weaken exports, which can cause the currency to depreciate further.
As I explained in my recent paper, we can think of two forces that affect the currency exchange rate - forces that work against each other and can therefore cancel each other out. In the paper, I derive how the exchange rate can theoretically remain constant; i.e., hold “stable” if the IRD change (dθ/dt) follows a path determined by the following equation:
where θ is the interest rate differential (IRD) at time t, and χ and γ are economy-dependent parameters.
The above equation suggests how it is theoretically possible to keep the currency stable forever. The problem however is that the IRD has to increase exponentially over time! If such an “elusive” path is followed long enough: ever-larger currency corrections or even a currency crash is likely to ensue. Obviously, such a policy must end at some point. Postponing the inevitable will only make things worse and can also erode credibility, translating into a lower χ, which induces a need to accelerate IRD changes even further! And the equation shows that no IRD change will suffice to maintain a stable currency, when the value of χ (aka “a credibility proxy”) approaches zero.
It is interesting to observe some of the paper’s empirical cases and how the IRD increased in a way closely resembling the elusive path and managed to keep the currency relatively stable — until it crashed. But despite its resembling the elusive path and the model’s prediction of a substantial currency correction, the large corrections actually occurred more than half a year later than the model predicted. The observed currency crashes of 2008 in Mexico, Chile, and Iceland all took place earlier than predicted. A likely explanation is that market participants simply outsmart policy-makers and/or the policy has lost its credibility. Policy-makers determine the input for the exchange rate model; i.e., the IRD time series. And if market participants can correctly predict what policy-makers will inevitably be forced to do - in this case, cut interest rates when faced with what we now call the “Great Recession” - they will outsmart hesitant policy makers.
The paper is published in the Journal of Applied Economics, an open access journal. It can be viewed here and also downloaded as a pdf document.
