In the late 1990s, several East Asian countries used limited flexibility or currency pegs in managing their exchange rates relative to the U.S. dollar. This question considers how different countries responded to the East Asian Currency Crisis (1997–1998). For the following questions, treat the East Asian country as the home country and the United States as the foreign country. Also, for the diagrams, you may assume these countries maintained a currency peg (fixed rate) relative to the U.S. dollar. Also, for the following questions, you need consider only the short-run effects.
a. In July 1997, investors expected that the Thai baht would depreciate. That is, they expected that Thailand’s central bank would be unable to maintain the currency peg with the U.S. dollar. Illustrate how this change in investors’ expectations affects the Thai money market and the FX market, with the exchange rate defined as baht (B) per U.S. dollar, denoted EB/$. Assume the Thai central bank wants to maintain capital mobility and preserve the level of its interest rate and abandons the currency peg in favor of a floating exchange rate regime.
b. Indonesia faced the same constraints as Thailand—investors feared Indonesia would be forced to abandon its currency peg. Illustrate how this change in investors’ expectations affects the Indonesian money market and the FX market, with the exchange rate defined as rupiahs (Rp) per U.S. dollar, denoted ERp/$. Assume the Indonesian central bank wants to maintain capital mobility and the currency peg.
c. Malaysia had a similar experience, except that it used capital controls to maintain its currency peg and preserve the level of its interest rate. Illustrate how this change in investors’ expectations affects the Malaysian money market and the FX market, with the exchange rate defined as ringgit (RM) per U.S. dollar, denoted ERM/$. You need show only the short-run effects of this change in investors’ expectations.
d. Compare and contrast the three approaches just outlined. As a policy maker, which would you favor? Explain.