Financial fragility and the exchange rate regime

Roberto Chang, Andrés Velasco

Research output: Contribution to journalArticlepeer-review

112 Scopus citations


We study financial fragility, exchange rate crises, and monetary policy in a model of an open economy with Diamond-Dybvig banks. The banking system, the exchange rate regime, and central bank credit policy are seen as parts of a mechanism intended to maximize social welfare; if the mechanism fails, banking crises and speculative attacks on the currency become possible. We compare currency boards, fixed rates, and flexible rates, with and without a lender of last resort. A currency board cannot implement a social optimum; in addition, it allows bank runs to occur. A fixed exchange rate system may implement the social optimum but is more prone to bank runs and exchange rate crises than a currency board. A flexible rate system implements the social optimum and eliminates runs, provided that the exchange rate and credit policies of the central bank are appropriately designed. Journal of Economic Literature Classification Numbers: F3, E5, G2.

Original languageEnglish (US)
Pages (from-to)1-34
Number of pages34
JournalJournal of Economic Theory
Issue number1
StatePublished - May 2000
Externally publishedYes

All Science Journal Classification (ASJC) codes

  • Economics and Econometrics


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