2. Literature Review
We can identify three different generations of models to explain currency crisis. The first generation models are theoretical ones and emerged as a consequence of the Latin American debt crisis at the beginning of 1980s. Developed on the arguments presented in Salant and Henderson  on speculative attacks on government-controlled price of gold, Krugman  introduced his model which assumed inevitable speculative attack in a fixed exchange rate regime when agents change composition of their portfolios from domestic to foreign currency, for instance, because of suspecting devaluation due to rising fiscal deficit. Crisis, then, may be triggered as a natural consequence as in that situation central reserve will be no longer enough to defend its currency (Chiodo and Owyang ). Flood and Garber  later developed a linear version of the Krugman  model for small economy. Though their model forecasted lower bounds for post-collapse exchange rates in a stochastic framework in access to predicting the timing and the probability of endogenous attack, likewise other deterministic models it considered attacks are predictable. First Generation Models dealt with a wide array of occasions. These models demonstrated that crisis not necessarily occurs due to irrationality of market participants, instead it arises due to their very rational expectations (Jeanne ). For instance, if reserve does not flee, speculators could forecast the period of devaluation and thus could be able to make sure profits. The core of this speculative-attack approach claims that reserve flight occurs during a currency crisis due to rational arbitrage. In general, these models coin their arguments on weak economic and financial fundamentals of a certain country which can make that country very suitable for speculative attack by international short term financial investors. Thus these models try to identify indicators of currency crisis. However, they are reluctant to identify underlying causes behind the crisis (Jeanne ). Moreover, they could not explain the rationale behind the spillover effect of crisis to other countries (Chiodo and Owyang ). Exchange Rate Mechanism (ERM) crisis of European Monetary System (EMS) in 1992-93 in Western Europe and crisis in Mexico in 1994-95 nullified the strength of First Generation Models as despite having sound fundamentals in terms of adequate international reserves, manageable domestic credit growth and non-monetized fiscal deficits, and good economic policies, some countries enormously failed to build protective shield against speculative attacks. Therefore, a broader and more holistic definition of determinants of currency credibility was required. As a result, a contentious argument was raised that the speculation did not entirely rely on economic fundamentals, rather it was also self-fulfilling. Features of self-fulfilling prophecies were entailed for developing Second Generation Models as per Obstfeld [6, 7], Obstfeld and Rogoff , Bensaid and Jeanne , and Velasco . These models incorporated the role of “expectations” of economic agents in predicting currency crisis and allowed for “multiple equilibria” while assuming monetary and fiscal policies to be exogenously set; thus these models shifted attention away from the foreign exchange reserves at central bank, the core of speculative attack in the models of Krugman  and Flood and Garber , to the decision exercising ability of an optimizing policymaker so as to devalue domestic currency. The momentum of currency movement is exposed to the degree at which private agents coordinate and hence multiple equilibria occur. Second Generation of Models, termed as “the escape clause” models, views fixed exchange rate arrangements as conditional commitment devices of a country which is often dependent on the will of policymakers. A currency crisis, in this scenario, may arise if private agents perceive government’s propensity to...
References: Krugman, P. (1979). A model of Balance-of-Payments crises. Journal of Money, Credit and Banking, vol. 11, pp. 311-325.
Chiodo, A. J., & Owyang, M. J. (2002). A case study of a currency crisis: The Russian default of 1998. Journal of Federal Reserve Bank of St. Louis, pp. 7-8.
Jeanne, O. (2000). Currency crises: A perspective on recent theoretical developments, Special papers in International Economics No. 20, International Finance Section, Princeton University.
Obstfeld, M., & Rogoff, K. (1995). The mirage of fixed exchange rates. Journal of Economic Perspectives, vol. 9, pp. 73-16.
Bensaid, B., & Jeanne, O. (1997). The instability of fixed exchange rate systems when raising the nominal interest rate is costly. European Economic Review, vol. 41, pp. 1461-1478.
Velasco, A. (1996). Fixed exchange rates: Credibility, flexibility and multiplicity. European Economic Review, vol. 40, pp. 1023-1035.
Jeanne, O. (1997). Are currency crises caused by the fundamentals or by self-fulfilling speculation? A test. Journal of International Economics, vol. 43, pp. 263-286.
Radelet, S. & Sachs, J. (1998). The East Asian financial crisis: Diagnosis, remedies, prospects. Harvard Institute for Development.
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