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Financial Fragility and the Exchange Rate Regime
Roberto Chang and Andres Velasco
Federal Reserve Bank of Atlanta
Working Paper 97-16
November 1997
Abstract: We study financial fragility, exchange rate crises, and monetary policy in an open economy version
of a Diamond-Dybvig model. 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 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 socially optimal allocation; in addition, bank
runs are possible under a currency board. 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 the exchange rate and central bank lending policies are
appropriately designed.
JEL classification: F3, E5, G2
Key words: exchange rates, financial crises, central bank policy
The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the
Federal Reserve System. Any remaining errors are the authors’ responsibility.
Please address questions regarding content to Roberto Chang, Research Department, Federal Reserve Bank of Atlanta, 104
Marietta Street, NW, Atlanta, Georgia 30303-2713, 404/521-8057, roberto.chang@atl.frb.org, or Andres Velasco,
Department of Economics, New York University, 269 Mercer Street, New York, New York 10003, 212/998-8958,
velasco@fasecon.econ.nyu.edu.
Questions regarding subscriptions to the Federal Reserve Bank of Atlanta working paper series should be addressed to the
Public Affairs Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, NW, Atlanta, Georgia 30303-2713,
404/521-8020. The full text of this paper may be downloaded (in PDF format) from the Atlanta Fed’s World-Wide Web
site at http://www.frbatlanta.org/publica/work_papers/.
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