Macroeconomics, 7e (Blanchard)Chapter 7: The Labor Market7.1 A Tour of the Labor Market1) Which of the following is considered out of the labor force?A) the unemployedB) those temporarily laid off who will soon be recalledC) those who worked full time, but in a family businessD) those individuals who have started searching for employment for the first timeE) none of the aboveAnswer: EDiff: 1Use the information provided below to answer the following question(s).The non-institutional civilian population is 250 million, of which 100 million are employed and 10 million are unemployed.2) Based on the information above, the unemployment rate isA) 4%.B) 6.6%.C) 9.1%.D) 10%.E) 11.1%.Answer: CDiff: 23) Based on the information above, the labor force participation rate isA) 36%.B) 40%.C) 44%.D) 90.1%.E) 66%.Answer: CDiff: 24) Based on the information above, the non-employment rate isA) 4%.B) 9.1%.C) 10%.D) 60%.E) 66%.Answer: DDiff: 25) Which of the following individuals would be considered unemployed?A) an individual who works only part-timeB) an individual who works full-time in a family business, but is not paidC) an individual who is not working and is not looking for workD) all of the aboveE) none of the aboveAnswer: EDiff: 26) Based on the data provided in the chapter, which of the following represents the largest component of the labor force?A) discouraged workersB) retired individualsC) employedD) unemployedAnswer: CDiff: 17) The labor force is defined asA) the sum of the employed and unemployed.B) the total number employed.C) the total number of working age individuals in the population.D) the sum of the number of employed, unemployed and discouraged individuals. Answer: ADiff: 18) The participation rate in the United States in 2010 was approximately equal toA) 96%.B) 90%.C) 65%.D) 26%.E) 5%.Answer: CDiff: 19) Which of the following represents the participation rate?A) the ratio of the number employed to the size of the labor forceB) the ratio of the number employed to the civilian noninstitutional populationC) the ratio of the labor force to the civilian noninstitutional populationD) the ratio of the labor force to the total number of employed and unemployed workers Answer: CDiff: 110) The average amount of time people spend unemployed is approximatelyA) 1 month.B) 6 months .C) 12 months.D) none of the aboveAnswer: DDiff: 211) The Current Population Survey interviews approximately how many households each month?A) 5,000B) 10,000C) 60,000D) 100,000Answer: CDiff: 112) In the United States, how many workers become unemployed, on average, every day?A) 5,000B) 10,000C) 50,000D) 100,000Answer: CDiff: 113) In the United States, the average length of time people spend unemployed isA) approximately one month.B) between two and three months.C) between ten and eleven months.D) greater than twelve months.Answer: BDiff: 214) A reduction in the unemployment rate will tend to cause which of the following?A) an increase in the separation rateB) a reduction in the nominal wageC) a reduction in the duration that one is unemployedD) none of the aboveAnswer: CDiff: 215) When the unemployment rate is low, we would expect thatA) the probability of losing a job is high.B) the probability of losing a job is low.C) the probability an unemployed individual will find another job is low.D) the separation rate will increase.Answer: BDiff: 216) The participation rate in the U.S. has increased steadily over time. First, explain what the participation rate represents. Second, explain why the participation rate has increased. Answer: The participation rate is the ratio of the labor force to the working age population. One of the reasons for the significant increase in the participation rate is the increasing participation of women in the labor force.Diff: 217) What effect does the existence of discouraged workers have on the ability of the official unemployment rate to provide accurate information about the extent to which labor is employed? Answer: Discouraged workers are individuals who have stopped searching for employment because, for example, they have become "discouraged" with the prospects of finding employment. Once they stop searching (after 4 weeks), they are no longer counted as unemployed and, therefore, in the labor force. Such a dynamic would cause the official unemployment to fall. Alternatively, the existence of discouraged workers implies that the official unemployment rate underestimates the extent to which labor is being is not being used. This explains why the existence of discouraged workers can cause the unemployment rate to be an imperfect measure of the utilization of labor.Diff: 218) First, provide a brief explanation of what the unemployment rate measures. Second, explain how changes in each of the components of the unemployment rate can cause changes in the unemployment rate.Answer: The unemployment rate measures the percentage of the labor force that is unemployed. The unemployment rate is based on a monthly survey of households. Individuals are classified as employed, unemployed, or out of the labor force. Individuals employed or unemployed are in the labor force. Suppose individuals decide to enter the labor force for the first time. This increase in the size of the labor force, all else fixed, would cause an increase in the unemployment rate.On the other hand, if there were an increase in the number of individuals unemployed (caused by, for example, firms laying off workers as demand for their products falls), we would observe no change in the labor force but an increase in the unemployment rate.Diff: 27.2 Movements in Unemployment1) Data on labor-force flows show thatA) almost all separations are due to death.B) almost all separations are due to serious illness.C) almost all separations are quits.D) almost all separations are layoffs.E) none of the aboveAnswer: EDiff: 22) Data on labor-force flows show thatA) in any given month, almost none of the unemployed gets jobs.B) in any given month, almost all of the unemployed gets jobs.C) the average duration of unemployment is about 2 weeks.D) the average duration of unemployment is about 2 years.E) in any given month, about one-fourth of the unemployed get jobs.Answer: EDiff: 23) Which of the following variables is most directly determined in the labor market?A) stock pricesB) nominal wagesC) interest ratesD) all of the aboveE) none of the aboveAnswer: BDiff: 14) The two labor markets in the "dual labor market" areA) southern versus northern.B) western versus eastern.C) English speaking versus non-English speaking.D) domestic versus foreign.E) none of the aboveAnswer: EDiff: 15) When the Current Population Survey (CPS) was introduced in 1940, it was based on a survey of approximately 8,000 households. The CPS survey is now based on a survey of how many households?A) 8,000B) 10,000C) 12,000D) 20,000E) 60,000Answer: EDiff: 26) As the unemployment rate falls,A) the proportion of the unemployed finding a job increases.B) the separation rate increases.C) the young and unskilled experience larger-than-average decreases in unemployment.D) both A and C.E) all of the aboveAnswer: DDiff: 27.3 Wage Determination1) Which of the following statements about wage setting is true?A) most workers in the U.S. have their wages set by formal contracts.B) formal contracts play a more important role in Japan and Western Europe than in the United States.C) the minimum wage in the U.S. is about 75% of the average wage.D) all of the aboveAnswer: BDiff: 12) The reservation wage isA) the wage that an employer must pay workers to reduce turnover to a reasonable level.B) the wage that ensures a laid-off individual will wait for re-hire, rather than find another job.C) the lowest wage firms are allowed by law to pay workers.D) the wage offer that will end a labor-strike.E) none of the aboveAnswer: EDiff: 13) Efficiency wage theory suggests thatA) workers will be paid less than their reservation wage.B) productivity might drop if the wage rate is too low.C) the government can only set tax rates so high before people will prefer not to work.D) unskilled workers will have a lower turnover rate than skilled workers.E) firms will be more resistant to wage increases as the labor market tightens. Answer: BDiff: 24) If efficiency wage theory is valid, we would expect a relatively low premium over the reservation wage whenA) the unemployment rate is low.B) the job requires very little training.C) workers can be easily monitored.D) workers have few other options for employment in the area.E) all of the aboveAnswer: CDiff: 25) Henry Ford's experiment with efficiency wages resulted inA) a dramatic drop in productivity.B) a dramatic increase in the turnover rate.C) a reduction in the layoff rate.D) new problems with the work force, like drunkenness and reckless driving.E) no noticeable effects.Answer: CDiff: 26) In the wage-setting relation, the nominal wage tends to decrease whenA) the price level increases.B) the unemployment rate decreases.C) unemployment benefits decrease.D) the minimum wage increases.E) all of the aboveAnswer: CDiff: 17) In the wage setting relation W = P e F(u,z), the variable z does not include which of the following variables?A) the minimum wageB) unemployment benefitsC) the extent to which firms mark up prices over their marginal costD) all of the aboveE) none of the aboveAnswer: CDiff: 18) Labor productivity is represented by which of the following?A) the ratio of output to employmentB) workers per unit of capitalC) capital per workerD) the ratio of output to populationE) the ratio of output to the labor forceAnswer: ADiff: 19) Today, about ________ of U.S. workers have their wages set by collective bargaining agreements.A) 10%B) 15%C) 20%D) 25%Answer: ADiff: 210) Explain several implications and characteristics of efficiency wage theories.Answer: The efficiency wage theory suggests that firms will pay workers a wage in excess of the workers' reservation wage to minimize quits and to increase productivity. The efficiency wage theory also suggests that nominal wages will be a function of labor market conditions. As the unemployment rate falls, the nominal wage will rise.Diff: 211) Explain how an increase in the unemployment rate will affect bargaining power and nominal wages.Answer: As the unemployment rate increases, it is more difficult for individuals to find employment at other firms. So, workers' bargaining power will fall. As bargaining power falls, the nominal wage will fall.Diff: 212) First, explain what the WS relation represents. Second, explain why it has its particular shape.Answer: The WS relation illustrates the effect of changes in the unemployment rate on the real wage implied by the wage-setting behavior of firms and workers. The WS curve (or relation) is downward sloping because as the unemployment rate increases, workers have less bargaining power so the nominal wage will decrease. This decrease in W, given P, implies that the real wage will also fall. Hence, the WS curve is downward sloping.Diff: 27.4 Price Determination1) The price setting equation is represented by the following: P = (1 + m)W. When there is perfect competition, we know that m will equalA) W.B) P.C) 1.D) W/P.E) none of the aboveAnswer: CDiff: 22) Explain why nominal wages are a function of the expected price level.Answer: Workers and firms care about the real wage. Nominal wages are typically set for a period of time by contracts. Individuals will, therefore, be concerned about what the future price level will be when determining the nominal wage. When setting the nominal wage, individuals will form expectations of what the future price level will be. They will use this to help determine the nominal wage.Diff: 27.5 The Natural Rate of Unemployment1) The natural rate of unemployment is the rate of unemploymentA) that occurs when the money market is in equilibrium.B) that occurs when the markup of prices over costs is zero.C) where the markup of prices over costs is equal to its historical value.D) that occurs when both the goods and financial markets are in equilibrium.E) none of the aboveAnswer: EDiff: 22) The natural level of output is the level of output that occurs whenA) the goods market and financial markets are in equilibrium.B) the economy is operating at the unemployment rate consistent with both the wage-setting and price-setting equations.C) the markup (m) is zero.D) the unemployment rate is zero.E) there are no discouraged workers in the economy.Answer: BDiff: 23) Suppose we wish to examine the determinants of the equilibrium real wage and equilibrium level of employment (N). In a graph with the real wage on the vertical axis, and the level of employment on the horizontal axis, the price-setting relation will now beA) a vertical line.B) a horizontal line.C) an upward sloping line.D) a downward sloping line.E) kinked at the natural rate of unemployment.Answer: BDiff: 24) Suppose we wish to examine the determinants of the equilibrium real wage and equilibrium level of employment (N). In a graph with the real wage on the vertical axis, and the level of employment on the horizontal axis, the wage-setting relation will now beA) a vertical line.B) a horizontal line.C) an upward sloping line.D) a downward sloping line.E) a curve that first slopes upward, then downward.Answer: CDiff: 25) The natural level of employment (N) will increase when which of the following occurs?A) an increase in the markup of prices over costsB) a reduction in unemployment benefitsC) an increase in the actual unemployment rateD) all of the aboveE) none of the aboveAnswer: BDiff: 26) Suppose workers and firms expect the overall price level to increase by 5%. Given this information, we would expect thatA) the nominal wage will increase by less than 5%.B) the nominal wage will increase by exactly 5%.C) the nominal wage will increase by more than 5%.D) the real wage will increase by 5%.E) the real wage will increase by less than 5%.Answer: BDiff: 27) Suppose the actual unemployment rate decreases. This will causeA) an upward shift in the WS curve.B) a downward shift in the WS curve.C) an upward shift in the PS curve.D) a downward shift in the PS curve.E) none of the aboveAnswer: EDiff: 28) Suppose the actual unemployment rate increases. This will causeA) an upward shift in the WS curve.B) a downward shift in the WS curve.C) an upward shift in the PS curve.D) a movement along the WS and the PS curves.E) none of the aboveAnswer: DDiff: 29) With the real wage on the vertical axis and the unemployment rate on the horizontal axis, we know thatA) the WS curve is upward sloping.B) the WS curve is downward sloping.C) the PS curve is upward sloping.D) the PS curve is downward sloping.Answer: BDiff: 210) Based on wage setting behavior, we know that a reduction in the unemployment rate will causeA) no change in the real wage.B) a reduction in the real wage.C) an increase in the real wage.D) an upward shift of the WS curve.Answer: CDiff: 211) Based on price setting behavior, we know that a reduction in the unemployment rate will causeA) no change in the real wage.B) a reduction in the real wage.C) an increase in the real wage.D) an upward shift of the PS curve.Answer: ADiff: 212) Suppose the aggregate production function is given by the following: Y = AN. Given this information, we know that labor productivity is represented by which of the following?A) 1/AB) AC) 1/ND) N/YAnswer: BDiff: 213) Suppose the aggregate production function is given by the following: Y = N. Given this information, we know that labor productivity is represented by which of the following?A) 1/NB) NC) N/YD) 1Answer: DDiff: 214) A reduction in unemployment benefits will tend to cause which of the following?A) an upward shift in the WS curveB) a downward shift in the WS curveC) an upward shift in the PS curveD) a downward shift in the PS curveE) none of the aboveAnswer: BDiff: 215) An increase in the minimum wage will tend to cause which of the following?A) an upward shift in the WS curveB) a downward shift in the WS curveC) an upward shift in the PS curveD) a downward shift in the PS curveE) none of the aboveAnswer: ADiff: 216) Suppose that increased international trade makes product markets more competitive in the U.S. Given this information, we would expect to observe which of the following?A) an upward shift in the WS curveB) a downward shift in the WS curveC) an upward shift in the PS curveD) a downward shift in the PS curveE) none of the aboveAnswer: CDiff: 217) With the real wage on the vertical axis and employment (N) on the horizontal axis, we know thatA) the WS curve is upward sloping.B) the WS curve is downward sloping.C) the PS curve is upward sloping.D) the PS curve is downward sloping.Answer: ADiff: 218) Based on our understanding of the labor market model presented in Chapter 6, we know that an increase in the minimum wage will causeA) an increase in the equilibrium real wage.B) a reduction in the equilibrium real wage.C) a reduction in the natural rate of unemployment.D) both B and CAnswer: ADiff: 219) Based on our understanding of the labor market model presented in Chapter 6, we know that an increase in the markup will causeA) an increase in the equilibrium real wage.B) a reduction in the equilibrium real wage.C) a reduction in the natural rate of unemployment.D) both B and CAnswer: BDiff: 220) Based on our understanding of the labor market model presented in Chapter 6, we know thata reduction in the markup will causeA) an increase in the equilibrium real wage.B) a reduction in the equilibrium real wage.C) an increase in the natural rate of unemployment.D) a reduction in the natural rate of unemployment and no change in the real wage.Answer: ADiff: 221) For this question, assume that Y = N. Based on our understanding of the labor market model presented in Chapter 6, we know that an increase in the minimum wage will causeA) an increase in the natural level of output.B) a reduction in the natural level of output.C) no change in the natural level of output.D) an increase in the natural level of employment.Answer: BDiff: 222) For this question, assume that Y = N. Based on our understanding of the labor market model presented in Chapter 6, we know that a reduction in the markup will causeA) an increase in the natural level of output.B) a reduction in the natural level of output.C) no change in the natural level of output.D) a reduction in the natural level of employment.Answer: ADiff: 223) Based on wage setting behavior, we know that an increase in the unemployment rate will causeA) no change in the real wage.B) a reduction in the real wage.C) an increase in the real wage.D) an upward shift of the WS curve.Answer: BDiff: 224) Based on price setting behavior, we know that an increase in the unemployment rate will causeA) no change in the real wage.B) a reduction in the real wage.C) an increase in the real wage.D) an upward shift of the PS curve.Answer: ADiff: 225) An increase in unemployment benefits will tend to cause which of the following?A) a downward shift in the WS curveB) an upward shift in the PS curveC) an upward shift in the WS curveD) a downward shift in the PS curveE) none of the aboveAnswer: CDiff: 226) A reduction in the minimum wage will tend to cause which of the following?A) an upward shift in the WS curveB) a downward shift in the WS curveC) an upward shift in the PS curveD) a downward shift in the PS curveE) none of the aboveAnswer: BDiff: 227) Explain what effect a reduction in the unemployment rate will have on the real wage based on: (1) the WS relation; and (2) the PS relation.Answer: A reduction in the unemployment rate will increase bargaining power, increase the nominal wage, and therefore increase the real wage based on wage setting behavior. Changes in the unemployment rate have no effect on the real wage based on price setting behavior.Diff: 228) First, explain what the PS relation represents. Second, explain why it has its particular shape. Answer: The PS relation illustrates the effect of changes in the unemployment rate on the real wage implied by the price-setting behavior of firms. Firms set prices as a markup over their marginal cost of producing goods. Given that the marginal cost is assumed to be independent of the level of employment (and, therefore, the unemployment rate), changes in u will have no effect on the price firms set and, therefore, on the real wage based on PS behavior.Diff: 229) Graphically illustrate (using the WS and PS relations) and explain the effects of an increase in the markup on the equilibrium real wage, the natural rate of unemployment, the natural level of employment, and the natural level of output.Answer: An increase in the markup will cause firms to raise the price given the nominal wage. This will cause the real wage based on price setting behavior to decrease; this is represented by a downward shift in the PS curve. This reduction in the real wage will also occur with an increase in the unemployment rate. So, the natural rate of unemployment will rise and the natural level of employment and, therefore, output will fall. The equilibrium real wage will also be lower. Diff: 230) Graphically illustrate (using the WS and PS relations) and explain the effects of an increase in the minimum wage on the equilibrium real wage, the natural rate of unemployment, the natural level of employment, and the natural level of output.Answer: An increase in the minimum wage will cause the nominal wage based on wage setting behavior to increase; this is represented as an upward shift in the WS relation. As the nominal wage increases, firms will respond by increasing the price level so we will observe no change in the equilibrium real wage. We will observe an increase in the natural rate of unemployment and a reduction in both the natural level of employment and output.Diff: 231) Based on your understanding of the labor market model presented by Blanchard (i.e., the WS and PS relations), explain what types of policies could be implemented to cause a reduction in the natural rate of unemployment.Answer: The natural rate of unemployment will change whenever either the PS or WS relations change. To reduce the natural rate, policy makers could implement polices that: (1) reduce unemployment benefits; (2) reduce the minimum wage; or (3) increase competition in product markets.Diff: 232) Explain how a reduction in the unemployment rate will affect bargaining power and nominal wages.Answer: As the unemployment rate decreases, it is easier for individuals to find employment at other firms. So, workers' bargaining power will increase. As bargaining power increases, the nominal wage will increase.Diff: 233) Graphically illustrate (using the WS and PS relations) and explain the effects of a reduction in the markup on the equilibrium real wage, the natural rate of unemployment, the natural level of employment, and the natural level of output.Answer: A reduction in the markup will cause firms to reduce the price given the nominal wage. This will cause the real wage based on price setting behavior to increase; this is represented by a upward shift in the PS curve. This increase in the real wage will also occur with an decrease in the unemployment rate. So, the natural rate of unemployment will decrease and the natural level of employment and, therefore, output will increase. The equilibrium real wage will also be higher.Diff: 234) Graphically illustrate (using the WS and PS relations) and explain the effects of a reduction in the minimum wage on the equilibrium real wage, the natural rate of unemployment, the natural level of employment, and the natural level of output.Answer: A reduction in the minimum wage will cause the nominal wage based on wage setting behavior to decrease; this is represented as an downward shift in the WS relation. As the nominal wage deceases, firms will respond by reducing the price level so we will observe no change in the equilibrium real wage. We will observe a decrease in the natural rate of unemployment and an increase in both the natural level of employment and output.Diff: 235) Explain what effect an increase in the unemployment rate will have on the real wage based on: (1) the WS relation; and (2) the PS relation.Answer: An increase in the unemployment rate will decrease bargaining power, decrease the nominal wage, and therefore decrease the real wage based on wage setting behavior. Changes in the unemployment rate have no effect on the real wage based on price setting behavior.Diff: 2。
Forthcoming in American Economic ReviewFirst Draft: December 1995This Version: November 9, 1998The Twin Crises: The Causes of Banking andBalance-of-Payments ProblemsGraciela L. Kaminsky Carmen M. Reinhart*AbstractIn the wake of the Mexican and Asian currency turmoil, the subject of financial crises has come to the forefront of academic and policy discussions. This paper analyzes the links between banking and currency crises. We find that: problems in the banking sector typically precede a currency crisis--the currency crisis deepens the banking crisis, activating a vicious spiral; financial liberalization often precedes banking crises. The anatomy of these episodes suggests that crises occur as the economy enters a recession, following a prolonged boom in economic activity that was fueled by credit, capital inflows and accompanied by an overvalued currency. (JEL F30, F41)* Graciela L. Kaminsky, George Washington University, Washington, D.C. 20552. Carmen M. Reinhart, University of Maryland, College Park, Maryland 20742. We thank two anonymous referees for very helpful suggestions. We also thank Guillermo Calvo, Rudiger Dornbusch, Peter Montiel, Vincent Reinhart, John Rogers, Andrew Rose and seminar participants at Banco de México, the Board of Governors of the Federal Reserve System, Florida State University, Harvard, the IMF, Johns Hopkins University, Massachusetts Institute of Technology, Stanford University, SUNY at Albany, University of California, Berkeley, UCLA, University of California, Santa Cruz, University of Maryland, University of Washington, The World Bank, and the conference on “Speculative Attacks in the Era of the Global Economy: Theory, Evidence, and Policy Implications,” (Washington, DC, December 1995), for very helpful comments and Greg Belzer, Kris Dickson, and Noah Williams for superb research assistance.Pervasive currency turmoil, particularly in Latin America in the late 1970s and early 1980s, gave impetus to a flourishing literature on balance-of-payments crises. As stressed in Paul Krugman’s (1979) seminal paper, in this literature crises occur because a country finances its fiscal deficit by printing money to the extent that excessive credit growth leads to the eventual collapse of the fixed exchange rate regime. With calmer currency markets in the mid- and late 1980s, interest in this literature languished. The collapse of the European Exchange Rate Mechanism, the Mexican peso crisis, and the wave of currency crises sweeping through Asia have, however, rekindled interest in the topic. Yet, the focus of this recent literature has shifted. While the earlier literature emphasized the inconsistency between fiscal and monetary policies and the exchange rate commitment, the new one stresses self-fulfilling expectations and herding behavior in international capital markets.1 In this view, as Guillermo A.Calvo (1995, page 1) summarizes “If investors deem you unworthy, no funds will be forthcoming and, thus, unworthy you will be.”Whatever the causes of currency crises, neither the old literature nor the new models ofself-fulfilling crises have paid much attention to the interaction between banking and currency problems, despite the fact that many of the countries that have had currency crises have also had full-fledged domestic banking crises around the same time. Notable exceptions are: Carlos Diaz-Alejandro (1985), Andres Velasco (1987), Calvo (1995), Ilan Goldfajn and Rodrigo Valdés (1995), and Victoria Miller (1995). As to the empirical evidence on the potential links between what we dub the twin crises, the literature has been entirely silent. The Thai, Indonesian, and Korean crises are not the first examples of dual currency and banking woes, they are only the recent additions to a long list of casualties which includes Chile, Finland, Mexico, Norway, and Sweden.In this paper, we aim to fill this void in the literature and examine currency and banking crises episodes for a number of industrial and developing countries. The former include: Denmark, Finland, Norway, Spain, and Sweden. The latter focus on: Argentina, Bolivia, Brazil, Chile, Colombia, Indonesia,1Israel, Malaysia, Mexico, Peru, the Philippines, Thailand, Turkey, Uruguay, and Venezuela. The period covered spans the 1970s through 1995. This sample gives us the opportunity to study 76 currency crises and 26 banking crises. Out-of sample, we examine the twin crises in Asia of 1997.Charles Kindelberger (1978, page 14), in studying financial crises, observes: “For historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general.” Like Kindelberger, we are interested in finding the underlying common patterns associated with financial crises. To study the nature of crises, we construct a chronology of events in the banking and external sectors. From this timetable, we draw inference about the possible causal patterns among banking and balance-of-payments problems and financial liberalization. We also examine the behavior of macroeconomic indicators that have been stressed in the theoretical literature around crisis periods, much along the lines of Barry Eichengreen et. al. (1996a). Our aim is to gauge whether the two crises share a common macroeconomic background. This methodology also allows us to assess the fragility of economies around the time of the financial crises and sheds light on the extent to which the crises were predictable. Our main results can be summarized as follows:First, with regard to the linkages among the crises, our analysis shows no apparent link between balance of payments and banking crises during the 1970s, when financial markets were highly regulated. In the 1980s, following the liberalization of financial markets across many parts of the world, banking and currency crises become closely entwined. Most often, the beginning of banking sector problems predate the balance of payment crisis; indeed, knowing that a banking crisis was underway helps predict a future currency crisis. The causal link, nevertheless, is not unidirectional. Our results show that the collapse of the currency deepens the banking crisis, activating a vicious spiral. We find that the peak of the banking crisis most often comes after the currency crash, suggesting that existing problems were aggravated or new ones created by the high interest rates required to defend the exchange rate peg or the foreign exchange exposure of banks.2Second, while banking crises often precede balance of payments crises, they are not necessarily the immediate cause of currency crises, even in the cases where a frail banking sector puts the nail in the coffin of what was already a defunct fixed exchange rate system. Our results point to common causes, and whether the currency or banking problems surface first is a matter of circumstance. Both crises are preceded by recessions or, at least, below normal economic growth, in part attributed to a worsening of the terms of trade, an overvalued exchange rate, and the rising cost of credit; exports are particularly hard hit. In both types of crises, a shock to financial institutions (possibly financial liberalization and/or increased access to international capital markets) fuels the boom phase of the cycle by providing access to financing. The financial vulnerability of the economy increases as the unbacked liabilities of the banking system climb to lofty levels.Third, our results show that crises (external or domestic) are typically preceded by a multitude of weak and deteriorating economic fundamentals. While speculative attacks can and do occur as market sentiment shifts and, possibly, herding behavior takes over (crises tend to be bunched together), the incidence of crises where the economic fundamentals were sound are rare.Fourth, when we compared the episodes in which currency and banking crises occurred jointly to those in which the currency or banking crisis occurred in isolation, we find that for the twin crises, economic fundamentals tended to be worse, the economies were considerably more frail, and the crises (both banking and currency) were far more severe.The rest of the paper is organized as follows. The next section provides a chronology of the crises and their links. Section II reviews the stylized facts around the periods surrounding the crises while Section III addresses the issues of the vulnerability of economies around the time of the crisis and the issue of predictability. The final section discusses the findings and possibilities for future research.I. The Links Between Banking and Currency CrisesThis section briefly discusses what the theoretical literature offers as explanations of the possible3links between the two crises. The theoretical models also guide our choice of the financial and economic indicators used in the analysis.A. The links: theoryA variety of theoretical models have been put forth to explain the linkages between currency and banking crises. One chain of causation, stressed in James Stoker (1995), runs from balance of payments problems to banking crisis. An initial external shock, such as an increase in foreign interest rates, coupled with a commitment to a fixed parity will result in the loss of reserves. If not sterilized, this will lead to a credit crunch, increased bankruptcies, and financial crisis. Moreover, Frederic Mishkin (1996) argues that, if a devaluation occurs, the position of banks could be weakened further if a large share of their liabilities is denominated in a foreign currency. Models, such as Velasco (1987), point to the opposite causal direction--financial sector problems give rise to the currency collapse. Such models stress that when central banks finance the bail-out of troubled financial institutions by printing money, we return to the classical story of a currency crash prompted by excessive money creation.A third family of models contend that currency and banking crises have common causes. An example of this may be found in the dynamics of an exchange rate-based inflation stabilization plan, such as that of Mexico in 1987. Theory and evidence suggest that such plans have well-defined dynamics: 2 Because inflation converges to international levels only gradually, there is a marked cumulative real exchange rate appreciation. Also, at the early stages of the plan there is a boom in imports and economic activity, financed by borrowing abroad. As the current account deficit continues to widen, financial markets become convinced that the stabilization program is unsustainable, fueling an attack against the domestic currency. Since the boom is usually financed by a surge in bank credit, as banks borrow abroad, when the capital inflows become outflows and asset markets crash, the banking system caves in. Ronald I. McKinnon and Huw Pill (1996) model how financial liberalization together with microeconomic distortions--such as implicit deposit insurance--can make these boom-bust cycles even more pronounced by4fueling the lending boom that leads to the eventual collapse of the banking system. Ilan Goldfajn and Rodrigo Valdés (1995) show how changes in international interest rates and capital inflows are amplified by the intermediating role of banks and how such swings may also produce an exaggerated business cycle that ends in bank runs and financial and currency crashes.So, while theory does not provide an unambiguous answer as to what the causal links between currency and banking crises are, the models are clear as to what economic indicators should provide insights about the underlying causes of the twin crises. High on that list are international reserves, a measure of excess money balances, domestic and foreign interest rates, and other external shocks, such as the terms of trade. The inflation stabilization-financial liberalization models also stress the boom-bust patterns in imports, output, capital flows, bank credit, and asset prices. Some of these models also highlight overvaluation of the currency, leading to the underperformance of exports. The possibility of bank runs suggests bank deposits as an indicator of impending crises. Finally, as in Krugman (1979) currency crises can be the byproduct of government budget deficits.B. The Links: Preliminary EvidenceTo examine these links empirically, we first need to identify the dates of currency and banking crises. In what follows, we begin by describing how our indices of financial crises are constructed. Definitions, dates, and incidence of crisesMost often, balance of payments crises are resolved through a devaluation of the domestic currency or the floatation of the exchange rate. But central banks can and, on occasion, do resort to contractionary monetary policy and foreign exchange market intervention to fight the speculative attack. In these latter cases, currency market turbulence will be reflected in steep increases in domestic interest rates and massive losses of foreign exchange reserves. Hence, an index of currency crises should capture these different manifestations of speculative attacks. In the spirit of Eichengreen, et. al. (1996 a and b), we constructed an index of currency market turbulence as a weighted average of exchange rate changes and reserve changes.35With regard to banking crises, our analysis stresses events. The main reason for following this approach has to do with the lack of high frequency data that capture when a financial crisis is underway. If the beginning of a banking crisis is marked by a bank runs and withdrawals, then changes in bank deposits could be used to date the crises. Often, the banking problems do not arise from the liability side, but from a protracted deterioration in asset quality, be it from a collapse in real estate prices or increased bankruptcies in the nonfinancial sector. In this case, changes in asset prices or a large increase in bankruptcies or nonperforming loans could be used to mark the onset of the crisis. For some of the earlier crises in emerging markets, however, stock market data is not available.4 Indicators of business failures and nonperforming loans are also usually available only at low frequencies, if at all; the latter are also made less informative by banks’ desire to hide their problems for as long as possible.Given these data limitations, we mark the beginning of a banking crisis by two types of events: (1) bank runs that lead to the closure, merging, or takeover by the public sector of one or more financial institutions (as in Venezuela 1993); and (2) if there are no runs, the closure, merging, takeover, orlarge-scale government assistance of an important financial institution (or group of institutions), that marks the start of a string of similar outcomes for other financial institutions (as in Thailand 1996-97). We rely on existing studies of banking crises and on the financial press; according to these studies the fragility of the banking sector was widespread during these periods. This approach to dating the beginning of the banking crises is not without drawbacks. It could date the crises too late, because the financial problems usually begin well before a bank is finally closed or merged; it could also date the crises too early, because the worst of crisis may come later. To address this issue we also date when the banking crisis hits its peak, defined as the period with the heaviest government intervention and/or bank closures.Our sample consists of 20 countries for the period 1970-mid-1995. The countries are those listed in the introduction and Appendix Tables 1 and 2. We selected countries on the multiple criteria of being small open economies, with a fixed exchange rate, crawling peg, or band through portions of the sample;6data availability also guided our choices. This period encompasses 26 banking crises and 76 currency crises.As to the incidence of the crises (Table 1 and Figure 1), there are distinct patterns across decades. During the 1970s we observe a total of 26 currency crises, yet banking crises were rare during that period, with only 3 taking place. The absence of banking crises may reflect the highly regulated nature of financial markets during the bulk of the 1970s. By contrast, while the number of currency crises per year does not increase much during the 1980s and 1990s (from an average of 2.60 per annum to 3.13 per annum, Table 1, first row), the number of banking crises per year more than quadruples in the post-liberalization period. Thus, as the second row of Table 1 higlights, the twin crisis phenomenon is one of the 1980s and 1990s.Figure 1 also shows that financial crises were heavily bunched in the early 1980s, when real interest rates in the United States were at their highest level since the 1930s. This may suggest that, external factors, such as interest rates in the United States, matter a great deal as argued in Calvo, et. al. (1993). Indeed, Jeffrey Frankel and Andrew K. Rose (1996) find that foreign interest rates play a significant role in predicting currency crashes. A second explanation why crises are bunched is that contagion effects may be present, creating a domino effect among those countries that have anything less than immaculate fundamentals. Sara Calvo and Reinhart (1996) present evidence of contagion in capital flows to Latin American countries while Eichengreen, et. al.(1996b) find evidence that knowing there is a crisis elsewhere increases the probability of a domestic currency crisis.Table 2 provides the dates of financial liberalization, the beginning and peak of the banking crisis, and the date of the balance of payments crisis that was nearest to the beginning of the banking crisis.5 By selecting the nearest currency crisis, whether it predates or follows the beginning of the banking crisis, we allow the data to reveal what the temporal patterns are. The dates for the remaining crises are given in the Appendix tables.The twin crises7We next examine how the currency and banking crises are linked. We begin by calculating the unconditional probability of currency crises and banking crises in our sample. For instance, the probability that a currency crisis will occur in the next 24 months over the entire sample is simply 24 times 76 (the total number of currency crises in the sample) divided by the total number of monthly observations in the sample. These calculations yield unconditional probabilities for currency and banking crises, which are twenty nine percent and ten percent, respectively (Table 3). The difference in the probabilities of the two kinds of crises highlights the relatively higher frequency of currency crises in the sample.We next calculate a family of conditional probabilities. For instance, if knowing that there is a banking crisis within the past 24 months helps predict a currency crisis then, the probability of a currency crisis, conditioned on information that a banking crisis is underway, should be higher than the unconditional probability of a balance of payments crisis. In other words, a banking crisis increases the probability that a country will fall prey to a currency crisis. This is precisely what the results summarized in Table 3 show. The probability of a currency crisis conditioned on the beginning of banking sector problems is 46 percent, well above the unconditional estimate 29 percent. Hence, it could be argued, as Diaz Alejandro (1985) and Velasco (1987) did for the Chilean crisis in the early 1980s, that, in an important number of cases, the bail-out of the banking system may have contributed to the acceleration in credit creation observed prior to the currency crises (see Herminio Blanco and Peter M. Garber (1986), Sebastian Edwards (1989), and Eichengreen et. al. (1996a), and this paper). Even in the absence of a large-scale bail-out, a frail banking system is likely to tie the hands of the central bank in defending the currency--witness Indonesia in August 1997.If, instead, the peak of the banking crisis is used as the conditioning piece of information, no valuable information is gained; indeed, the conditional probability is 22 percent and below the unconditional. This result follows from the fact that a more common pattern (see Table 2) appears to be that the peak of the banking crisis comes after the currency crisis. For instance, knowing that there is a8currency crisis does not help predict the onset of a banking crisis, this conditional probability is 8 percent; knowing that there was a currency crisis does help to predict the probability that the banking crisis will worsen, this conditonal probability is 16 percent.Taken together, these results seem to point to the existence vicious circles. Financial sector problems undermine the currency. Devaluations, in turn, aggravate the existing banking sector problems and create new ones. These adverse feedback mechanisms are in line with those suggested by Mishkin (1996) and can be amplified, as we have seen in several of the recent Asian crises, by banks’ inadequate hedging of foreign exchange risk. The presence of vicious circles would imply that, a priori, the twin crises are more severe than currency or banking crises that occur in isolation.To measure the severity of a currency crisis, we focus on a composite measure that averages reserve losses and the real exchange rate depreciation.6 For reserves, we use the six-month percent change prior to the crisis month, as reserve losses typically occur prior to the devaluation (if the attack is successful). For the real exchange rate, we use the six-month percent change following the crisis month, because large depreciations occur after, and only if, the central bank concedes by devaluing or floating the currency. This measure of severity is constructed for each currency crisis in our sample and the averages are reported in Table 4 separately for the 19 twin crises in our sample and for the others. In line with our results that the beginning of the banking crisis precedes the balance of payments crisis, we define the twin crises as those episodes in which a currency crisis follows the beginning of the banking crisis within the next 48 months. For banking crises, we use the bail-out costs, as a percent of GDP, as the measure of severity. As Table 4 highlights, bail-out costs are significantly larger (more than double) in the twin crises than for banking crises which were not accompanied by a currency crisis. As to balance of payments crises, the results are mixed. Reserve losses sustained by the central bank are significantly bigger (Table 4) but the real depreciations are of comparable orders of magnitude.Our results also yield an insight as to the links of crises with financial liberalization (Table 3). In918 of the 26 banking crises studied here, the financial sector had been liberalized during the preceding five years, usually less. Only in a few cases in our sample countries, such as the early liberalization efforts of Brazil in 1975 and Mexico in 1974, was the liberalization not followed by financial sector stress. In the 1980s and 1990s most liberalization episodes have been associated with financial crises of varying severity. Only in a handful of countries (for instance, Canada which is not in the sample) did financial sector liberalization proceed smoothly. Indeed, the probability of a banking crisis (beginning) conditional on financial liberalization having taken place is higher than the unconditional probability of a banking crisis. This suggests that the twin crises may have common origins in the deregulation of the financial system and the boom-bust cycles and asset bubbles that, all too often, accompany financial liberalization. The stylized evidence presented in Gerald Caprio and Daniela Klingebiel (1996) suggests that inadequate regulation and lack of supervision at the time of the liberalization may play a key role in explaining why deregulation and banking crises are so closely entwined.II. The Macroeconomic Background of the CrisesTo shed light on whether both types of crises may have common roots, we analyze the evolution of 16 macroeconomic and financial variables around the time of the crises. The variables used in the analysis were chosen in light of theoretical considerations and subject to data availability. Monthly data was usedto get a clearer view (than would otherwise be revealed by lower frequency data) of developments as the crisis approaches and by the desire to evaluate to what extent these indicators were giving an early signal of impending trouble--an issue that will be taken up in the next section.The indicators associated with financial liberalization are the M2 multiplier, the ratio of domestic credit to nominal GDP, the real interest rate on deposits, and the ratio of lending-to-deposit interest rates. Other financial indicators include: excess real M1 balances, real commercial bank deposits, and the ratioof M2 (converted into U.S. dollars) divided by foreign exchange reserves (in U.S. dollars).7 The indicators linked to the current account include the percent deviation of the real exchange rate from trend, as a10measure of misalignment, the value of exports and imports (in U.S. dollars), and the terms-of-trade.8 The indicators associated with the capital account are: foreign exchange reserves (in U.S. dollars) and the domestic-foreign real interest rate differential on deposits (monthly rates in percentage points). The indicators of the real sector are industrial production and an index of equity prices (in U.S. dollars). 9 Lastly, the fiscal variable is the overall budget deficit as a percent of GDP.Of course, this is not an exhaustive list of potential indicators. In particular, political variables, such as the timing of an election, can also be linked to the timing of these crises. Indeed, the evidence presented in Deepak Mishra (1997), who examines a subset of the currency crises in this study, suggests that devaluations, more often than not, follow elections. Indeed, an election raises the probability of a future devaluation, even after controlling for economic fundamentals.Except for the interest rate variables, the deviations of the real exchange rate from trend, our proxy for excess real M1 balances, and the lending/deposit interest rates ratio, which are in levels, we focus on the 12-month percent changes of the remaining 10 variables. The pre- and post-crises behavior of all variables is compared to the average behavior during tranquil periods, which are all the remaining observations in our sample and serves as our control group.Figures 2, 3, and 4 illustrate the behavior of the variables around the time of the balance of payments, banking crises, and twin crises, respectively; each panel portrays a different variable. The horizontal axis records the number of months before and after the beginning of the crises; the vertical axis records the percent difference (percentage point difference for interest rates) between tranquil and crisis periods. In all the figures the solid line represents the average for all the crises for which data was available.10 Hence, if no data points are missing, the solid line represents the average behavior of that indicator during the months around 76 currency crises and 26 banking crises. For Figures 2 and 3, the dotted lines denote plus/minus one standard error around the average. For example, the top center panel of Figure 2 shows that, on average, the 12-month growth in the domestic credit/GDP ratio is about 15 percent11higher than in tranquil times. In Figure 4 the solid line shows the evolution of the indicators for the twin crises episodes while the dashed line denotes the averages for the currency crises that were not accompanied by a banking crisis.For currency crises we focus on the 18-month period before and after the crisis. Unlike balance of payments crises, in which reserves are lost abruptly and currency pegs abandoned, banking crises are protracted affairs which tend to come in waves and, hence, the depth of the crisis is seldom reached at the first sign of outbreak (see Table 2). For this reason, we widen the window and focus on the 18 months before the onset of the crisis, a 18-month arbitrarily chosen crisis period, and the 18 months post-crisis period. At any rate, because most of our analysis focuses on the causes leading up to the crises, our main results will not be affected whether the crises lasted less or more than a year. For the 19 episodes of the twin crises, we focus on the 18 months prior to the balance of payments crisis. Given that banking crises usually predate currency crises in our sample, this implies we are already looking at a period of heavy financial sector stress.A. The Financial SectorUntil the 1970s, most financial markets were regulated with rationed credit and, often, negative real interest rates. The late 1970s and beginning of the 1980s, however, witnessed sweeping financial reforms both in developed and emerging markets, which led to, among other things, increases in real interest rates. 11 Because financial liberalization often precedes banking crises--the indicators associated with financial liberalization presented in the first four panels of Figures 2, 3, and 4 (from left to right) merit scrutiny. The growth in the M2 multiplier rises steadily up to nine months prior to the currency crisis and the onset of the banking crisis; indeed, for banking crises the multiplier grows at above normal rate in the entire 18 months prior to the crisis. The draconian reductions in reserve requirements that often accompany financial liberalization play a role in explaining the large increases in the M2 multiplier. Yet the rise in the multiplier prior to currency crises is entirely accounted for by its evolution ahead of the twin12。
Moderate Inflation Is Beneficial to SocietyIn economics, inflation is the phenomenon of prices of goods and services generally rising in an economy during a period of time (Barro 895). There are complex factors contributing to the phenomenon and yet no economist has a definite conclusion. Inflation is more commonly induced by increases in aggregate demand (Gordon 728). Through analyzing the causes, it is believed that moderate inflation is beneficial to society in many aspects.Demand inflation is generally induced by private and government spending and it’s good for economic recovery.The financial crisis of 2007 to 2008 overwhelmed the world and many countries faced recession. Governments delivered a series of policies to restore their economies. For instance, China initiated the positive fiscal policy and launched an economic stimulus package of 4000 billion (</ens/finance_investment/2009/03/07/ 131626.shtml>). The Congress in the United States of America also approved the policy of Quantitative Easing (</Html/JR WZ/0981420071375442.html>). What those governments did definitely caused inflation but at that time inflation was needed because they could stimulate market demand, which was good for economic recovery.Demand inflation encourages market development and expansion is inevitable, which can definitely reduce the unemployment rate. In 1958, Phillips described in a paper his observation an inverse relation between inflation and unemployment, that is higher unemployment in an economy is correlated witha lower rate of inflation (Fisher 496-502). According to the statistics from the EU, the unemployment rate of the Euro Zone in march of 2009 is 8.9% and the inflation rate was 0.6% (</roll/20090507/634391.shtml>). In China and other developing countries, the unemployment rate is relatively lower and the inflation rate is higher. For China, unemployment rate is approximately 4% and the inflation rate is nearly 5% (Cara Associated Press, retrieved 30 Dec, 2010.). These examples explicitly indicate the inverse relation between inflation and unemployment rate.Demand inflation somewhat indicates that money in the market increased, which is partly caused by increasing investment, including investment in non-profit capital projects. During 2009 to 2010, China was under the condition that the inflation rate was relatively high and China’s government simultaneously invested more money in the countryside to reinforce foundation construction and improve healthcare (Bradsher The New York Times,19 Feb 2008). Currently, China’s inflation rate is comparatively lower tha n that a few years ago and its investment in foundation construction and healthcare has decreased. The comparison illustrates the positive correlation that moderate inflation and non-profit capital investment.The above information demonstrates that inflation does not merely have disadvantages as is generally considered, but it also was some advantages. Moderate inflation is beneficial to economic recovery, descent of unemployment rate and non-profit capital projects. If governments can handleinflation well, it will greatly prompt social development. However, we should also be aware that inflation cannot be excessive. Otherwise it will jeopardize society.Works CitedBarro, Robert J. Macroeconomics: 1997. Cambridge, Mass: MIT Press. Bradsher, Keith. “China’s Inflation Rose to 7.1% in January.”New York Times19 February, 2008.Cara, Anna. “China Inflation Rate at 5.1 Percent.”(December 12, 2010).Associated Press. Retrieved December 30, 2010.Fisher, Irving. “I Discovered the Phillips Curve—A Statistical Relation between Unemployment and Price Changes.”The Journal of Political Economy, Vol.81, No. 2, Part 1 (Mar. - Apr., 1973), pp. 496-502.Gordon, Robert J. Macroeconomics—Theory and Policy, 2nd ed. Chicago: University of Chicago Press,1988The website of China Financialyst 中国金融家. Jinrong Weiji Dashiji 金融危机大事记”The Chronicle of Financial Crises.” 14 August 2009 <http://www./Html/JRWZ/0981420071375442.html>The Website of Chinese Minister of Commerce 中国商务部网站. Ouyuanqu Chengxian Gaoshiyelv He Ditongzhanglv Bingcun Jumian 欧元区呈现高失业率和低通胀率并存局面”High Unemployment Rate And Low Inflation Rate are Both Exist in Euro Area.” 07 May 2009 </ roll/20090507/634391.shtml>The Website of Economics Observer. “China's Stimulus Package: A Breakdown of Spending.”07 March 2009 </ens/finance_investment/2009/03/07/131626.shtml>。
