Economic History in the Making, Iceland’s “el error de diciembre”
As an economics student one of the most fascinating topics I ever studied was the Mexican Peso Crisis (nicknamed “el error de diciembre”, in
Monetary Economics 101 - A brief background.
Currencies are traded on an open market. Businesses make transactions in a specific currency, and then deposit those transactions in a bank. The bank acts as a clearinghouse by trading large quantities of their deposits on the foreign exchange market so they can provide domestic currency to customers at local branches. The foreign exchange market determines the currency’s value using a supply and demand model.
The demand side of the market, can be described through a simplistic example. An Icelandic businessman makes a transaction in dollars, deposits the dollars in his Icelandic account, the Icelandic bank trades dollars for Krona in the foreign exchange market, then the Icelandic businessman is able to withdraw Krona and use it to buy things. This basic process happens in bulk countless times throughout the day, more demand to change dollars into Krona will push the value of Krona (relative to dollars) up.
The supply side of the market is controlled by a Country’s central bank. A central bank uses open market operations to reduce or increase the amount of currency in circulation, thereby inflating or deflating the currency. An open market operation can be demonstrated through another very simplified example. The Icelandic Central Bank holds several different currencies including U.S. Dollars. Through a direct open market transaction it can “buy” Krona using its dollars, then hoard the purchased Krona, thereby reducing the supply of Krona in circulation. Central banks can also indirectly effect the money supply through the interest rate (in the
During a currency crisis there is a sudden drop in demand for the at-risk currency. There is a fear that a country is having some catastrophic problem, and will not be able to control the value of the currency through an open market operation. As demand for the currency drops, the value of the currency (in relation to other currencies) follows. A central bank can raise interest rates and/or buy domestic currency directly in the foreign exchange market using foreign denominated assets (from the example above a central bank can take all the US dollars it holds and buy as many Krona as possible to hoard from the market, which decreases supply). These actions will attempt to curb the fleeting value of the domestic currency measured as the inflation rate. The problem is if the fear factor that set off the crisis cannot be stemmed. As world demand for a currency spirals downward a central bank will have an increasingly difficult time keeping up on the supply side. Just as a bank run this is a self fulfilling prophecy, a country’s currency is perceived to be highly risky, so demand for the currency drops, and that makes the currency even more risky. A central bank will continue to fight the run on the currency by continuing to contract the money supply, but once this snowball starts it is often difficult to stop.
This crisis also has far reaching effects on the domestic economy. With the central banks raising the interest rate there is an automatic cooling effect on the economy, unemployment will start to creep up and business credit will slow. For small and developing countries there is often a huge problem with foreign debts. If a business has any debts denominated in foreign currency a rapid inflation can be devastating. For example if I owe someone $100 when 1 dollar = 1 Krona, and now 1 dollar – 10 Krona my debt just increased to $1,000. Multiply by the billions of dollars in trade and even the slightest drop in value could bankrupt a country.
What happened to
On October 7th
The central bank followed protocol, and raised its key interest rate 6 points overnight on October 28th, putting the rate at 18%. The estimated $6 billion IMF loan will be denominated in dollars giving some added protection to shore up the currency but the country is facing some serious economic hardship ahead, adding fuel to the problem.
To add insult to injury
 This is not the only currency crisis occurring right now. There is the well known currency crisis that has gone on for a long time in
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