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The Logic of Currency Crises
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1994
Year
Unknown Venue
Governments defend fixed exchange rates using reserves and policy options, but the decision to abandon a peg depends on how speculative expectations and price changes influence government economic and political positions, creating self‑fulfilling crises that previous literature largely ignores. The study introduces two models showing how crises and realignments arise from interactions between rational private actors and a government pursuing clear policy objectives. Both models illustrate that arbitrary shifts in expectations can transform a credible exchange‑rate peg into a fragile one. The paper argues that existing literature fails to explain events like the 1992‑93 European Exchange Rate Mechanism collapse.
Once one recognizes that governments borrow international reserves and exercise other policy options to defend fixed exchange rates during currency crises, the question arises: What factors determine a government's decision to abandon a currency peg or hang on? In a setting of purposeful action by the authorities, the possibility of self-fulfilling crises becomes important. Speculative anticipations depend on conjectured government responses, which depend, in turn, on how price changes that are themselves fueled by expectations affect the government's economic and political positions. The circular dynamic implies a potential for crises that need not have occurred, but that do because market participants expect them to. In contrast to this picture, most previous literature on balance-of- payments crises ignores the response of government behavior to markets. That literature, I argue, throws little light on events such as the European Exchange Rate Mechanism collapse of 1992-93. This paper then presents two different models in which crisis and realignment result from the interaction of rational private economic actors and a government that pursues well-defined policy goals. In both, arbitrary expectational shifts can turn a fairly credible exchange-rate peg into a fragile one.