DP2170 | Currency Crises: A Perspective on Recent Theoretical Developments

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28/06/1999

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Abstract

This paper puts recent theoretical developments in the literature on currency crises in perspective by comparing two theoretical approaches, one based on the speculative attack model of Krugman-Flood-Garber and the other approach, which evolved following the 1992-93 crisis of the European Monetary System, and that we call here "escape clause". The escape clause approach broadens the set of fundamentals to nonmonetary variables, including unemployment or the state of the banking sector, and even "softer" fundamentals such as the reputation of the policymaker and the rules of the game played by the participants in a fixed exchange rate arrangement. It also suggests that the relationship between the economic fundamentals and devaluation expectations is in general nonlinear, and may give rise to multiple equilibria. We argue that, while the speculative attack approach provides useful insights on the anatomy of currency crises, it must be complemented by the escape clause approach if one wants to understand the underlying causes of the crises that we have witnessed in the 1990s.