currency crises models

Abstract

Currency crises have occurred frequently in the postwar era. In this article we review the literature on the causes and consequences of currency crises. First-generation models attribute a central role to fiscal policy as a fundamental determinant of crises. Second-generation models emphasize the possibility of self-fulfilling speculative attacks and multiple equi-libria. Third-generation models stress how financial fragility can lead to currency crises. There have been many currency crises during the postwar era (see Kaminsky and Reinhart 1999). A currency crisis is an episode in which the exchange rate depreciates substantially during a short period of time. There is an extensive literature on the causes and consequences of a currency crisis in a country with a fixed or heavily managed exchange rate. The models in this literature are often categorized as first-, second-or third-generation. In first-generation models the collapse of a fixed exchange rate regime is caused by unsustainable fiscal policy. The classic first-generation models are those of Krugman (1979) and Flood and Garber (1984). These models are related to earlier work by Henderson and Salant (1978) on speculative attacks in the gold market. Important extensions of these early models incorporate consumer optimization and the govern-ment's intertemporal budget constraint into the analysis (see Obstfeld 1986; Calvo 1987; Drazen and Helpman 1987; Wijnbergen 1991). Flood and Marion (1999) provide a detailed review of first-generation models.