The cause of currency crises

on July 12 2013 10:38 AM
Arrangement of various world currencies including Chinese Yuan, Japanese Yen, US Dollar, Euro, British Pound, Swiss Franc and pictured in Warsaw
Arrangement of various world currencies including Chinese Yuan, Japanese Yen, US Dollar, Euro, British Pound, Swiss Franc and pictured in Warsaw, January 26, 2011. REUTERS

In order to manage a currency crisis, selling off foreign currency to mop up local currency averts a long term crisis.

The article discusses the causes of a currency crisis and the determination of how certain factors affect the overall value of currency and its effect on investors.

Basically, a currency crisis results from a decline in the value of a specific currency. The declines impact an economy negatively as it creates instability or fluctuations in the exchange rate. This is brought about by the interaction between investor expectations and the effects that these expectations that occur thereafter.

One of the common actions undertaken when a specific economy is experiencing or is projected to undergo a currency crisis, the country's central banks would shore up the value of the local currency through deposits made from their current foreign reserves. The difference that is covered is the pegged exchange rate and the actual value of the currency vis a vis another currency,

Why then is the foreign reserve of a country affected? This is because when devaluation occurs, there is downward pressure on the currency that can only be counteracted by the interest rate. Increasing the interest rate requires the decrease of the money supply which in turn triggers an increase in demand for the currency, In order to create capital outflows, foreign reserves are sold off and payment would be made in the domestic currency, creating a locally denominated asset.

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