Question

In the late 1990s, several East Asian countries used limited flexibility or currency pegs in managing their exchange rates relative to the U.S. dollar. This question considers how different countries responded to the East Asian currency crisis (1997-1998). For the following questions, treat the East Asian country as the home country and the United States as the foreign country. Also, for the diagrams, you may assume these countries maintained a currency peg (fixed rate) relative to the U.S. dollar. Also, for the following questions, you need consider only the short-run effects. a. In July 1997, investors expected that the Thai baht would depreciate. That is, they expected that Thailand's central bank would be unable to maintain the currency peg with the U.S. dollar. Illustrate how this change in investors' expectations affects the Thai money market and FX market, with the exchange rate defined as baht (B) per U.S. dollar, denoted EB/s​. Assume the Thai central bank wants to maintain capital mobility and preserve the level of its interest rate, and abandons the currency peg in favor of a floating exchange rate regime. b. Indonesia faced the same constraints as Thailand-investors feared Indonesia would be forced to abandon its currency peg. Illustrate how this change in investors' expectations affects the Indonesian money market and FX market, with the exchange rate defined as rupiahs (Rp) per U.S. dollar, denoted ERp/s​. Assume that the Indonesian central bank wants to maintain capital mobility and the currency peg. c. Malaysia had a similar experience, except that it used capital controls to maintain its currency peg and preserve the level of its interest rate. Illustrate how this change in investors' expectations affects the Malaysian money market and FX market, with the exchange rate defined as ringgit (RM) per U.S. dollar, denoted ERM/8​. You need show only the short-run effects of this change in investors' expectations. d. Compare and contrast the three approaches just outlined. As a policymaker, which would you favor? Explain.

Answer 1

a. If investors expect the Thai baht to depreciate, the demand for baht will fall, causing a shift to the left in the demand for baht curve (Dbaht). At the same time, the supply of baht will increase, causing a shift to the right in the supply of baht curve (Sbaht). The equilibrium exchange rate (EB/s) will fall, and the Thai central bank will need to sell U.S. dollars from its foreign exchange reserves to maintain the currency peg. However, if the Thai central bank wants to maintain capital mobility and preserve the level of its interest rate, it may choose to abandon the currency peg in favor of a floating exchange rate regime. In that case, the exchange rate will be determined by market forces.

b. If investors expect Indonesia to abandon its currency peg, the demand for U.S. dollars will increase, causing a shift to the right in the demand for U.S. dollars curve (D$). At the same time, the supply of U.S. dollars will decrease, causing a shift to the left in the supply of U.S. dollars curve (S$). The equilibrium exchange rate (ERp/s) will rise, and the Indonesian central bank will need to intervene in the foreign exchange market by selling rupiahs and buying U.S. dollars to maintain the currency peg and preserve capital mobility.

c. If investors expect Malaysia to abandon its currency peg, the demand for U.S. dollars will increase, causing a shift to the right in the demand for U.S. dollars curve (D$). However, Malaysia had imposed capital controls to limit capital outflows and maintain the currency peg. As a result, the supply of ringgit will not increase, and the exchange rate will remain fixed at ERM/8. However, the capital controls may disrupt the functioning of the Malaysian money market and lead to other economic distortions.

d. The three approaches differ in how they respond to changes in investor expectations about the exchange rate. Thailand chose to abandon the currency peg and allow the exchange rate to float, while Indonesia chose to maintain the currency peg and intervene in the foreign exchange market to preserve capital mobility. Malaysia imposed capital controls to maintain the currency peg and preserve the level of its interest rate. As a policymaker, the choice of approach will depend on a country's specific circumstances and policy objectives. A floating exchange rate regime may provide more flexibility to respond to external shocks, but it may also lead to greater exchange rate volatility. A fixed exchange rate regime may provide stability, but it may also require frequent intervention in the foreign exchange market to maintain the currency peg. Capital controls may be effective in the short run, but they may also discourage foreign investment and lead to other distortions.