The emergence of currency crises

With the end of the Bretton Woods system in the 1970s and the financial market liberalisation in the 1980s and 1990s, the international economy has experienced several financial crises in certain countries or regions entailing, in most cases, declines in economic activity and large output losses. This has occurred regardless of whether the exchange rates were pegged or flexible. There appear to be destabilising mechanisms at work from which even a flexible exchange rate regime cannot escape. In this chapter we review some of the stylised facts that appear to be common to such financial crises and develop a Mundell–Fleming–Tobin (MFT) type model based on Rødseth (2000, Ch. 6). Our approach builds on Miller and Stiglitz (1999) and takes up Krugman's (1999a, 1999b, 1999c and 2001) suggestions in order to study the real and financial crises generated by large exchange rate swings.

With respect to exchange rate shocks due to currency runs triggering financial and real crises, there are three views, in fact three generations of models, that have been presented in the literature. The first view maintains that news on macroeconomic fundamentals (such as differences in economic growth rates, productivity differences and differences in price levels, in short-term interest rates as well as in monetary policy actions) may cause currency runs. The second view maintains that speculative forces drive exchange rates where there can be self-fulfilling expectations at work, destabilising exchange rates without deterioration of fundamentals.