Firm Liquidation and Economic Crisis Under Unexpected
Exchange Rate Shock

Qiang Gong

Shen Jia

and

Justin Yifu Lin

This paper studies the causes, mechanisms and consequences of decreasing firm value and welfare loss in an economy under a fixed exchange rate regime when there is an unexpected appreciation in domestic currency. We also study the possible economic crisis caused by the exchange rate shock. We consider the established production capacity as well as the training of firm specific labors before production to obtain that unexpected appreciation in domestic currency leads to unemployment of firm workers as well as a decrease in the firm’s output and revenue. Furthermore, when the exchange rate appreciates to a certain degree, it is likely to induce economic crisis—firms will stop production completely which will not only decrease the firm’s value, but also create a greater loss of social welfare due to the waste of existing capacity and human capital in the economy. Our study also implies that when an economy shifts from a fixed exchange rate regime to a more flexible one, government could adopt gradual reform policies and partial deregulation of the exchange rate to reduce or prevent social welfare loss when domestic currency faces appreciation pressure.