| Describe the mechanisms
by which a currency crisis affects a real economy
Currency Crisis: currency crisis
can not be defined in a universal sense .The forms are different
in different times and regions, but most would agree that
they all involve one key element: investors fleeing a currency
en masse out of fear that it might be devalued, in turn fuelling
the very devaluation they anticipated. Although such crises--the
Latin American debt crisis of the 1980s, the speculations
on European currencies in the early 1990s, and the ensuing
Mexican, South American, and Asian crises--have played a central
role in world affairs and continue to occur at an alarming
rate, many questions about their causes and effects remain
to be answered. In this wide-ranging volume, some of the best
minds in economics focus on the historical and theoretical
aspects of currency crises to investigate two fundamental
issues:
What drives currency crises?
And what are the actual consequences to the real economy?
The Real Economy & its factors: Real economy
is defined as the physical side of the economy dealing with
goods, services and resources. This side is concerned with
using resources to produce the goods and services that make
the satisfaction of wants and needs possible. This should
be contrasted with the paper economy, or financial side of
the economy.  The Factors of Real Economy:
Price Level: The average of the
prices of goods and services produced in the aggregate economy.
In a theoretical sense, the price level is the price of aggregate
production.
Output: A generic term for a tangible good or an intangible
service that is the end result of the production/resource
transformation process. This notion of output, which also
goes by the alias product, usually surfaces in the context
of analyzing the short-run production of a firm.
Import & Export: Goods and services produced
by the foreign sector and purchased by the domestic economy.
In other words, imports are goods purchased from other countries.
Export is t he sale of goods to a foreign country.
Exchange Rate: The price of one nation's
currency in terms of another nation's currency. This is often
called the foreign exchange rate in that it is the price determined
in the foreign exchange market.
Consumption: The use of resources, goods,
or services to satisfy wants and needs. At the microeconomic
level, consumption is primarily analyzed in the context of
utility, demand and their importance to market exchanges.
Employment: The condition in which a resource
(especially labour) is actively engaged in a productive activity
usually in exchange for an explicit factor payment (such as
wage or salary).
Inflation: A persistent increase in the average
price level in the economy. Inflation occurs when the aggregate
price level (increases over time. Inflation results when the
average of these assorted prices follows an upward trend.
Inflation is the most common phenomenon associated with the
price level.
The Effects on parameters by currency Crisis:
Exchange Rates:
The exchange rate has been severely affected by the currency
crisis following the canonical Krugman (1979) model; a balance
of payments crisis (currency depreciation; loss of foreign
exchange reserves; collapse of a pegged exchange rate) arises
when domestic credit expansion by the central bank is inconsistent
with the pegged exchange rate. Often, as in the Krugman model,
the credit expansion results from the monetization of budget
deficits. Foreign exchange reserves fall gradually until the
Central Bank is vulnerable to a sudden run, which exhausts
the remaining reserves, and pushes the economy to a floating
rate in defense
of a pegged exchange rate (as in Thailand and the Philippines)
or a crawling peg (as in Indonesia, Malaysia, and Korea).
Import & Export
Import: The import gets severely
affected by the currency factor .The currency depreciation
leads to higher cost of import making it unviable for the
consumption. This leads to lower economic activity.
Export: The currency crisis immediately leads
to maintaining the trade gap as the lack of foreign currency
leads to higher trade imbalance, it forces the economy to
react through higher foreign borrowing or import compression
which leads to lower levels of consumption and/or through
higher export .The absence of these could lead to output contraction
(example Cuba)
Output and, Inflation and Price levels:
The currency crisis can be linked with fixed and semi fixed
regimes. An appreciation of the pegged currency leads to less
cost competitiveness and leading to stagnation in the output
levels and eventually leads to investments in speculative
investments leading to higher inflation. In case of Asian
Currency crisis, real estate was under speculative attacks.
Before the currency crisis the higher output leads to a feeling
of high current and future expected growth lead to higher
consumption and less savings The higher capital accumulation
leading to higher inflation.
The higher icor
indicating non-sustainability of the output level and signs
of speculative investments before the currency meltdown. During
the currency crisis, capital flight from the real economy
and the speculative investments leads to lower output .The
effect can be seen directly on the GDP levels as visible in
case of Indonesia the GDP has gone down by 2%
IMF Indonesia .In case of Cuba when there was no speculative
investment but trade sanctioned lead to output contraction
as a reaction to trade imbalance .
The currency melt down is preceded by speculative investments;
lower savings rate fuels inflation.
After the debacle the panic and the continuous depreciation
of the currencies against the standard currencies leads to
a high inflation rate to accommodate the continuous decline
in currency values till the stabilization takes place. The
inflation affects the price levels to a great extent .The
price levels shift towards accommodation the uncertain inflation
rates and the output levels.
Consumption & Employment
Consumption: The consumption level reduces
as the price levels and inflation level changes and the effect
is aggravated by the lower unemployment rates because of the
capital flight from the real economy leading to job losses.
The panic also reduces the consumption level .The previous
low savings rate due to the expectancy of continuity of the
economic growth leads to a shift towards saving and that lowers
the consumption creating a stagnation of output leading to
adjustments through employment reductions and that again adds
to economic uncertainty and creates a cycle of downturn.
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