ECON 20 Lecture Notes - Lecture 26: Economic And Monetary Union Of The European Union, Currency Crisis, Aggregate Demand

1 views2 pages
19 Oct 2020
Department
Course
Professor
Jeff Koo
Econ 20
Introductory Economics
Fall 2018
4 Units
Problem with debt denominated in foreign currency rather than domestic currency
Most countries borrow in foreign currency. This means that if Mexico borrows from the
United States, it will have to pay back the debt in dollars, not pesos.
Debt denominated in foreign currency can get a country into trouble if the exchange rates
change. For example, prior to the East Asian crisis of the late 1990s, those countries were
rapidly developing. They therefore borrowed money from the U.S. to fund their growth.
(For example, they might borrow dollars to purchase U.S. machinery to improve their
manufacturing capital, enhancing their supply-side potential output.) When the Asian Crisis
hit, the affected countries’ currencies depreciated dramatically. Therefore, their debt is the
same in dollars, but increases significantly when measured in their own currency. As their
currencies depreciated, it became much more difficult for these countries to service their
foreign debt.
a. To pay back the debt, countries may be forced to pursue “austerity” policies that cut
spending, and therefore lower aggregate demand (demand-side theory at work again).
b. Austerity may take place through reduced government spending, but also by
restrictions on new credit to the private sector that forces reductions in private
consumption and investment.
There is another channel at work as a debtor's currency depreciates. Its exports become
cheaper and thus increase and imports become more expensive and thus decrease. As a
result, a large currency depreciation will likely create a net inflow of "hard" currency into the
country. The depreciated currency also lowers imports and boosts exports, restoring the
aggregate demand that was lost in the crisis described in the previous note.
o This process operates more slowly than the crisis situation described above (which
can unfold in a matter of days, even hours). So shifts in international trade do not
prevent the crisis.
o But it is often the case that currency depreciation helps rapidly indebted countries
recover from currency crises, usually in a matter of a year or two.
The European Union countries that run into debt problems face difficulties that, in one sense,
are more difficult to solve.
o These countries have foreign debts denominated in various currencies, but largely in
euros.
o If the perception in international markets is that these debts have become too high,
they must pay back the euros by reducing domestic absorption of goods and services.
This leads to reduced living standards.
o But because these countries are part of the European Monetary Union (often called
the EMU), their currencies cannot depreciate relative to other European countries.
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