Search Results

This chapter discusses the basic analytical framework of “first-generation” models of currency crises and their extensions to deal with important features of balance-of-payments crises such as alternative post-collapse regimes, capital control and borrowing constraints, interest rate defence policies, the interaction between bank solvency and currency stability, uncertainty about government policies, real effects of crises. The key implication of this approach is that a fixed exchange rate regime cannot survive the long-run inconsistency between monetary, fiscal, and exchange rate policies. Unnecessary domestic money growth leads to a persistent loss of reserves and ultimately to a speculative attack against the home currency that forces the government to switch out of the peg once reserves approach a minimum level. It also predicts that the attack will take place at the point where the shadow exchange rate (i.e., the rate that would prevail if the government diverted into a floating rate) equals the fixed peg.

In order to describe the path followed by major macroeconomic variable around the time of crises, this chapter examines some dynamic models. It thus shows how the dynamic adjustment path of the economy associated with exchange rate based stabilization plan can be linked to currency crisis. How expected changes in future government's policies can affect the timing of attacks. How a run on central bank's foreign reserves can emerge in a context of consistent and flexible policy rules. How policymakers can elude speculative attacks by introducing uncertainty into the speculators' decisions. That the domestic currency often stays overvalued for a long period. That large discrete devaluations occur after the peg is abandoned. That the domestic interest rates tend to rise in the run up to the crisis. That speculative runs often occur in a multi-period context giving rise to alternating phases of “tranquillity” and “distress”. That asset price dynamics plays a critical role in triggering a full-blown financial crisis.

This chapter revisits first the crisis of the European Exchange Rate Mechanism in the early 1990s to address the question why decision makers of very different countries agreed on forming a currency union. The policy architecture that was built for the euro area was single-mindedly focused on stability-oriented monetary policy and prudent fiscal policy. This was meant to protect the commons of a currency providing low inflation but also low interest rates. This interpretation goes against the reading that the European monetary union followed a neoliberal script. Some risk sharing was built into the policy framework, although this emerged only over time, for instance when the ECB had to defend its collateral policy. However, the risks from financial integration were clearly underestimated. Cross-border capital flows financed catch-up growth but they also led to unprecedented macroeconomic imbalances.