Financial fragility and the exchange rate regime

We study financial fragility, exchange rate crises, and monetary policy in a model of an open economy with Diamond-Dybvig banks. The banking system, t he exchange rate regime, and central bank credit policy are seen as parts o f a mechanism intended to maximize social welfare; if the mechanism fails, banking crises and speculative attacks on the currency become possible. We compare currency boards, fixed rates, and flexible rates, with and without a lender of last resort. A currency board cannot implement a social optimum ; in addition, it allows bank runs to occur. A fixed exchange rate sq stem may implement the social optimum but is more prone to bank runs and exchang e rate crises than a currency board. A flexible rate system implements the social optimum and eliminates runs, provided that the exchange rate and cre dit policies of the central bank are appropriately designed. Journal of Eco nomic Literature Classification Numbers: F3, E5, G2. (C) 2000 Academic Pres s.