TY - JOUR AU - Chang, Roberto AU - Velasco, Andres TI - Financial Fragility and the Exchange Rate Regime JF - National Bureau of Economic Research Working Paper Series VL - No. 6469 PY - 1998 Y2 - March 1998 DO - 10.3386/w6469 UR - http://www.nber.org/papers/w6469 L1 - http://www.nber.org/papers/w6469.pdf N1 - Author contact info: Roberto Chang Rutgers University Department of Economics 75 Hamilton Street New Brunswick, NJ 08901 Tel: 732/932-7269 Fax: 732/932-7416 E-Mail: chang@econ.rutgers.edu Andrés Velasco Columbia University School of International and Public Affairs 420 West 118th Street New York, NY 10027 Tel: 212/854-3899 E-Mail: avbranes@gmail.com AB - We study financial fragility, exchange rate crises and monetary policy in an open economy model in which banks are maturity transformers as in Diamond-Dybvig. 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 rate and flexible rates, with and without a lender of last resort. A currency board cannot implement a socially optimal allocation; in addition, under a currency board bank runs are possible. 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. Larger capital inflows enhance welfare if the no-run equilibrium occurs, but may also render the economy more vulnerable to self-fulfilling runs. A flexible exchange rate system implements the social optimum and eliminates runs, provided the exchange rate and central bank lending policies of the central bank are appropriately designed. ER -