DP2929 | Nominal Debt and the Dynamics of Currency Crises

Publication Date

22/08/2001

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Abstract

This Paper proposes a new framework for interpreting a currency crisis associated with a fiscal imbalance, which we find appropriate for the analysis of contemporary economies with outstanding public debt. Unlike the first-generation literature on speculative attacks, we do not assume that money growth finances the imbalance and that governments face exogenous borrowing constraints. In our model, the cause of a devaluation is a fiscal policy switch, from a policy-backing government debt fully with taxes, to one using taxes and unanticipated inflation. Its timing depends on the interaction of fiscal and monetary policy, where the latter is modelled in terms of interest rate rules. Real debt acts as leverage, and the rate of devaluation is smaller when nominal liabilities are a larger fraction of the total. The focus of our analysis of currency crises is on currency of denomination and maturity of government debt; the government's willingness to tolerate high interest rates; the possibility of coordination problems among holders of government debt.