Depreciation bias, financial-sector fragility and currency risk

Abstract

Do expected future exchange rate fluctuations affect current social welfare? In the third-generation approach to currency crises, financial fragility can trigger devaluation and default. Expected future depreciation is costly if it raises ex ante real interest rates. Given the strong violation of uncovered interest parity, expected future outcomes' current cost/benefit depends on the currency risk premium. I extend the static one-period Barro-Gordon welfare loss function to include expected future depreciation and show that, when foreign investors are risk-averse, depreciation bias is higher than the static case if aggregate demand is a function of ex ante real rates. If demand depends on the ex post real interest rate, average depreciation can be zero if current welfare is sufficiently sensitive to the state of the financial sector. In this stylised framework, depreciation bias can be mitigated even in the presence of time-inconsistency, and expected welfare may be higher.