A currency crisis occurs because of the drop in the value of a nation’s currency. This drop in value has a negative impact on the economy, and Currency Crisis also creates instability in exchange rates, which means one unit of currency no more values as it is used to in another. Currency Crisis also emerges from an interaction between the expectations of investors and the outcomes of those expectations.
The role of investors, Central Banks and Government Policies
During the prospect of a currency crisis, the lenders try to manage the fixed rate by consuming the country’s foreign reserves. At that time, they had no concern about fluctuation of exchange rate.
Why is penetrating into foreign reserves a quick fix? When the market is hoping for devaluation, then the downward pressure laid on the currency can prove to be a compensation by an increase in the interest rate. The central bank has to shrink the money supply in order to increase the rate, which in turn increases the current demand. Foreign reserves are sold to maintain a capital effluence. When a portion of foreign reserves is sold by the bank, it obtains payment to hold out of circulation as a resource in the form of the domestic currency.
Sustaining the exchange rate cannot last forever, both in terms of a downfall in foreign reserves as well as economic and social factors, such as emerging unemployment. Lowering the value of the currency by increasing the fixed exchange rate leading to the devaluation of domestic goods than foreign goods, which blooms demand for the workers and increases the outcome. The interest rates increase in the short run devaluation, which must be balanced by the central bank through an increase in the financial supply and enhancing foreign reserves. As mentioned earlier, sustaining a fixed exchange rate can consume the country’s reserves quickly, and lowering the value of the currency can preserve foreign reserves.
The investors are good at making strategies for their expectations, beneficial for you. If the market wants to devalue the currency through the central bank, would increase the exchange rate, the feasibility of increasing foreign reserves through an increase in aggregate demand is not known. Rather, the central bank must utilize its reserves to lower the money supply, which in turn raises the domestic interest rate.
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