DP2149 | A Krugman-Dooley-Sachs Third Generation Model of the Asian Financial Crisis

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This paper presents a multiple-equilibrium model of the Asian financial crisis. The economy has Krugman-style over-investment caused by weak financial regulation and exacerbated by government guarantees. Following Dooley, the government only has a limited capacity or willingness to honour such guarantees. The model has a unique long-run equilibrium, with over-investment. But in the short run, in which the capital stock is fixed, it also has multiple equilibria. If lenders regard lending as low-risk, then it is. But if they regard lending as high-risk then the cost of honouring guarantees rises, making the lending high-risk and the risk premium self-justifying. We argue that this model usefully captures the ideas of panic and collapse which have been popularised in Sachs' discussions of the Asian crisis.