Currency Swap Agreements and Financial Crises in Small Open Economies

Abstract

This paper studies the effects of an international currency swap agreement, or an exchange of hard currencies between countries, on the probability of financial crises. The analysis is based on a small open economy model with a financial constraint. A currency swap is described as a mutual provision of collateral goods between two countries. The results show that there are cases where a currency swap agreement can lower the probability of financial crises. Whether it can benefit both member countries depends on their difference in the size or probability of recessions, as well as the amount of collateral goods exchanged. Contracts of cunency swaps should be designed in consideration of these factors.