The International Economy And Its Far Reaching Financial Crises

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The interconnectedness of the international economy and its far-reaching financial crises has convinced many to start rethinking the international finance system once more. In short, there is a need for an LOLR (international lender of last resort) due to the fact that international capital flows are not only immensely volatile but also influential in destabilizing other countries. Many argue that an LOLR can help mitigate the effects of instability and help countries facing a crisis to restabilize. In industrialized countries, domestic central banks have the ability to do this with the lender of last resort operation in which the central bank lends freely during a financial crisis. However, central banks in emerging market countries are…show more content…
As a result, no bank runs occurred and a panic was avoided. The advantage to having a LOLR in a developed country is that it can be a lender of last resort not only to banks but also the the entire system. This is exemplified in 1987 when the stock market crashed but the Federal Reserve was able to offer liquidity to those that would make loans to the securities industry. The end result was a negligible impact on the economy and a small amount of liquidity needed to be provided by Fed needed to remedy the situation.
An LOLR becomes problematic in emerging markets in developing countries for a number of reasons. First, many emerging market countries have most of their debt denominated in foreign currency. Second, since their history of high and variable inflation have resulted in debt contracts, expansionary monetary would cause expected inflation to rise drastically and domestic currency to depreciate sharply. As a result, a LOLR has a much lower success rate than a developed country’s. From a larger perspective, the depreciation of the domestic currency leads to a deterioration in firms ' and banks ' balance sheets because much of their debt is denominated in foreign currency. This raises the burden of indebtedness and lowers banks ' and firms ' net worth. Third, the sharp rise of expected inflation would cause interest rates to rise as well due to the need to protect lenders from the loss of purchasing power when they lend.
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