European Business Schools Librarian's Group

ESSEC Working Papers,
ESSEC Research Center, ESSEC Business School

No DR 03011: Financial Instability under Floating Exchange Rates

Damien Besancenot () and Radu Vranceanu ()
Additional contact information
Damien Besancenot: University of Paris 2 and ERMES, Postal: 92 rue d'Assas, 75007 PARIS, FRANCE
Radu Vranceanu: ESSEC Business School, Postal: Avenue Bernard Hirsch - B.P.105, 95021 CERGY-PONTOISE CEDEX FRANCE

Abstract: At the end of the nineties, many developing countries featured an open capital market and relied heavily on dollar-debt financing of their economy. This paper analyses whether, in this context, clean floating can be a sustainable policy choice. The model is cast as a game between successive generations of investors who decide whether they buy or not the debt of a representative firm. The exchange rate is subject to random shocks, which makes uncertain the private sector’s solvency. We show that a small risk of insolvency would bring about a much larger risk of illiquidity. A rational expectation equilibrium without default can be put forward only in the highly improbable case when the currency is extremely overvalued. The case against flexible exchange rates may be stronger than usually thought.

Keywords: Floating; Rational Expectations; Financial Crises; Developing Countries

JEL-codes: F30; G15

30 pages, March 2003

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