However, devaluation was supposed to restore their competitiveness and stimulate their economies. Instead, these devaluations produced recessions. There are many reasons why a devaluation might produce a recession. For example, by raising the cost of imported intermediate inputs, a devaluation can have adverse supply-side effects. While there are many possibilities, this Letter argues that in the case of the recent Asian crisis, a combination of financial market imperfections and inadequate regulation provides a particularly likely explanation.
Impulses are shocks that get things rolling.
Propagation mechanisms are structural features of the economy that prolong, and possibly even amplify, the effects of shocks. The conventional view of the impulse is as follows. Market participants recognize that in the event of a bad shock to the economy, governments will find it politically difficult not to bail out the banking system. Knowing this, banks will tend to engage in excessively risky lending. After all, if nothing bad happens, management and shareholders reap the rewards of high-yielding risky investments, while if things do turn sour, the taxpayers are left holding the bag.