Currency crises are characterized by two seemingly contradictory features. On the one hand, currency crises are usually “large,” in that they involve massive asset reallocations, wild swings in asset prices, and heavy output losses. On the other hand, currency crises are often triggered by shocks that seem too small to account for these effects. Although these characteristics of crises might suggest some form of irrationality, the literature has provided two types of models that account for some of these features in an environment in which agents are rational.
First generation models of currency crises, starting with Krugman (1979) and Flood and Garber (1984a), view crises as arising from inconsistent policies; in particular, monetization of fiscal deficits together with fixed exchange rates. In these models, the drop in demand for real balances at the time of the crisis leads to a discrete drop in reserves at the Central Bank, even in the absence of a corresponding discrete deterioration in fundamentals. Although these models account for large “attacks,” they have the counterfactual implication that these attacks should be predictable and, consequently, lead to no discrete changes in the exchange rate or other asset prices.
Second generation models of currency crises, starting with Obstfeld (1986), account for the unpredictability of crises by assuming the existence of multiple equilibria. In these models, consumers’ expectations can be self-fulfilling because they affect the Central Bank’s decision of whether to devalue. One drawback of these models is that they have little to say about the dynamics and timing of crises, as these depend on unmodelled expectational dynamics.
Furthermore, Morris and Shin (1998) show that the existence of multiple equilibria in second generation models may not be robust to the inclusion of private information. Morris and Shin present a canonical second generation model and show that, when consumers have private information about the level of fundamentals, the model has a single equilibrium. As a result, in their environment the indeterminacy on which second generation models depended to account for unpredictable crises and discrete drops in asset prices disappears.
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Discrete Devaluations and Multiple Equilibria in a First Generation Model of Currency Crises
