1st Generation Currency Crisis Model

A currency crisis is a type of financial crisis. It is a situation when there is serious doubt if the central banks have enough foreign exchange reserves to maintain the peg of the currency. The crisis is often accompanied by speculative attacks in the forex market. A currency crisis may result due to a chronic balance of payments deficit.

1st Generation model

Assumptions: (monetary model with UIP)
1. Small open economy
2. PPP holds (assuming p*=0)

3. UIP holds (assuming i*=0)

4. Output is exogenous
5. Perfect foresight

Thus, (assuming y=0) we get,

So, it can be observed money supply determines the exchange rate in the long run.

Now, we assume the economy has two parts, firstly, the government which is running a deficit. Secondly, the Central bank which has to finance the government's deficit by buying government bonds and at the same time also defend the peg. Thus, the central bank has two objectives which are inconsistent and therefore, the currency would subsequently collapse.

Central bank's balance sheet:

where former are domestic bonds and the latter is foreign bonds in issuer's currency. The central bank is increasing domestic credit or buying government bonds at the rate of u  (mew)

As the former keeps on rising, to maintain money supply and subsequently the peg, the central bank depletes its foreign exchange reserve.

Thus, the central bank will eventually run out of reserves and the currency will collapse.  The question, however, arises as to when would the collapse occur?

Let, s_tilda be the exchange rate that would prevail if the attack has already happened or when the central banks have no reserves. So,

 where,

The currency collapses when,

1. If the former is less than the latter then collapse would not occur since the shadow exchange rate is lower than the official rate. Therefore, agents know that if the collapse occurs in such time they would cause the currency to appreciate and would lead to negative return for them and so there is no speculative attack under this scenario.
2. If the former is greater than the latter then this would incentivise agents to give currency before this period since the currency is depreciating.
3. Thus, collapse occurs only when the former equals the latter.

The model also predicts that the exchange rate will have to be abandoned before the central bank has completely exhausted its reserves through debt monetization. Why? Otherwise, there would have to be a perfectly anticipated discrete rise in the exchange rate. Such a jump implies an instantaneously infinite rate of capital gain.

So, higher is the foreign reserve stock and slower is the rate of domestic credit growth, longer is the period of time before a crisis occurs. Analytically, it can be calculated by the following method:

Issues with the model:

1. According to this model, the underlying reason for the currency to collapse is reckless money creation due to irresponsible fiscal policies. However, in many actual cases, like the 1992 sterling crisis, the fiscal issue did not exist.

2. Government's objectives have not been modelled. Apart from focusing to maintain the peg, the government also cares about other factors in the economy like the unemployment rates. Second generation model, therefore, takes the government's objectives into account.

Difficulties with pegging exchange rates:

Suppose, the financial markets expect a devaluation. Then according to UIP, the central banks should increase the interest rates. The required increment of interest rates could be substantial, which therefore may harm other sectors of the economy (like investments, unemployment). Thus, even the government might not be willing to cling to the pegged rate since it might take other factors of the economy into consideration. This would be further developed in 2nd generation models. Alternatively, the central bank might try to persuade that it would not devalue the currency at any cost or might increase interest rates but less than the necessary levels. In the long run, these anecdotes would not work. 

Example: 1992 European Monetary Crisis (EMS)

In 1992, financial markets were convinced that currency devaluation would occur. Thus, they started demanding higher interest rates, which created difficulties for countries to maintain parity. Thus, some countries (e.g. Spain) devalued their currency. Some countries (e.g. UK) suspended from EMS. Some countries (Sweden) raised interest rates by 500% but it did not work and later they let krona float.

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