Basics of Currency Crisis: 3 generation models and Russian 1998 crisis case study

St. Louis Fed economists Abbigail Chiodo and Michael Owyang, have a super paper on currency crisis.

They begin to discuss what a currency crisis is and its impact of the economy. They then discuss the 3 generation currency crisis models: 

  • First Generation: It was developed by Krugman (1979) and developed by Flood and Garber (1984). This model explains that a currency crisis will result if the govt has huge deficits and there is a fixed exchange rate. If expectations start to build that govts will be unable to finance the deficit and could monetize the deficit. The monetization could result in high inflation. This could lead to foreign outflows and a speculative attack on the domestic currency. The attack could initially be defended by forex reserves. But if the attack grows and central bank is unable to defend the currency and does not have adequate reserves, it could result in devaluation. A sudden devaluation of a fixed exchange rate leads to collapse of the exchange rate system and leads to a crisis
  • Second Generation: First G model could not explain the contagious currency crisis. For instance, we saw South East Asian crisis becoming a contagious crisis spreading from one region to the other. The 2nd generation model explains these events via trade channel or via neighbouring trade partners or via having similar macroeconomic attributes or via financial channel.
  • Third Generation: First G and Second G models did not provide policy prescriptions. First G model actually says crisis cannot be thwarted once expectations of devaluation sets in.  Typical prescription for a currency crisis is to raise interest rates and prevent capital outflows. However, Third G model says a currency crisis leads to number of problems in the economy and higher interest rates would create more damage to the economy. The 3 G models instead suggest to keep real interest rates low and keep financial system functioning in the crisis (make banks give credit etc)

The 3 models together tell you 4 factors that lead to a currency crisis:

  • Domestic Public and Private debt
  • Expectations
  • State of financial markets
  • Pegged exchange rate

The authors then use the lessons learnt from the 3 models and apply to Russian crisis of 1998. All the 3 models and the four factors help explain the crisis.

Wonderful reading. It tells you so much about currency crisis in so few pages.

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7 Responses to “Basics of Currency Crisis: 3 generation models and Russian 1998 crisis case study”

  1. Don Draper Says:

    I would also add to the list – going off the gold standard and the use of fiat currencies.

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    great read, thanks

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