The last decade of the twentieth century witnessed a number of currency crises affecting the international financial markets. The economies of the various countries which suffered financial crises and attacks on their currencies from international speculators were, moreover, quite diverse. They ranged from a number of Latin American economies, where economists were quick to point out apparent inconsistencies between the stance of domestic macroeconomic policy and a commitment to a fixed exchange rate; to advanced European economies where there appeared to be no such inconsistencies but instead a perceived temptation of the authorities to pursue more of an expansionary domestic policy; to the ‘tiger economies’ of East Asia, where, prior to the crisis, the economic fundamentals appeared very strong and macroeconomic policy appeared entirely consistent with the fixed exchange rate rule.
Accordingly, a literature has sprung up in recent years in order to explain these phenomena. In this chapter we briefly review this work. There are three main strands of this literature, broadly corresponding to the three cases discussed above, and we shall tackle them in turn.
First-generation currency crisis models
The first strand of the literature – often referred to as the first-generation currency crisis approach – starts with the seminal article by Krugman (1979), itself largely drawing on previous related work by Salant and Henderson (1978). Krugman (1979) builds a model of a small open economy and shows that, under a fixed exchange rate regime, excess creation of domestic credit relative to money demand growth may generate the conditions for a sudden speculative attack against the domestic currency, ultimately leading to the abandonment of the fixed exchange rate peg and the switch to a flexible exchange rate.