Exam 8: Why Do Financial Crises Occur and Why Are They so Damaging to the Economy

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In the second stage of a financial crisis in an emerging economy, a speculative currency attack begins. The government may find it difficult to defend itself from such an attack for several reasons.

Firstly, the government may have limited foreign exchange reserves, making it challenging to intervene in the currency market to support the value of the domestic currency. This could be due to a combination of factors such as a large current account deficit, high levels of external debt, or a sudden outflow of foreign capital.

Secondly, the government may face pressure from international financial markets and investors, who may view the country as having weak economic fundamentals. This could lead to a loss of confidence in the domestic currency, making it even more difficult for the government to stabilize its value.

Additionally, the government may be constrained by its monetary policy options. If the country is already experiencing high inflation or interest rates, the central bank may be limited in its ability to raise interest rates further to defend the currency without causing further damage to the domestic economy.

Furthermore, the government may also face political challenges in implementing effective policy responses to a currency attack. This could be due to domestic opposition to measures such as austerity or currency devaluation, which may be necessary to restore confidence in the economy.

Overall, in the second stage of a financial crisis in an emerging economy, a speculative currency attack can be difficult for the government to defend against due to limited reserves, external pressures, constrained monetary policy options, and political challenges.

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The "twin crises" in an emerging economy financial crisis refer to the simultaneous occurrence of a currency crisis and a banking crisis. A currency crisis occurs when a country's currency experiences a sharp devaluation or depreciation, leading to a loss of confidence in the currency and potentially triggering capital flight. A banking crisis, on the other hand, occurs when the financial sector is under stress, with banks facing insolvency and liquidity problems. When both of these crises occur at the same time, it can have severe and far-reaching effects on the economy, leading to a deep recession, high inflation, and a loss of investor confidence. The term "twin crises" highlights the interconnected nature of these two types of crises and their compounding impact on the overall financial stability of an emerging economy.