Currency Crises

Currency crises are sudden and significant fluctuations in ex rates, caused by speculative attacks on a country’s currency;

• leads to forced devaluation and possible debt default.

• they can also be caused by;

  • fiscal imbalances,

  • external shocks,

  • financial sector vulnerabilities, and

  • shifts in market expectations.

First generation models of currency crises

• Characteristics: focuses on unsustainable fiscal policies as triggers for currency crises in fixed ex rate regimes such as;

  • high budget deficits,

  • high inflation rates,

  • and external debt levels.

• Limitations: they oversimplify complexities of crises by neglecting the role of expectations

  • especially about devaluations and investor behaviour.

  • unable to explain why crises spread or speculative attacks happen.

Second generation models

• Characteristics: focuses on the role of expectations and self-fulfilling prophecies;

  • emphasises investor confidence + coordination in influencing markets.

  • explains how crises spread to and affect other markets due to changes in shared behaviours, trade links and expectations.

• Limitations: they often assume investors behave rationally;

  • overlooks irrationality and imperfect information.

  • lacks concrete policy suggestions and failed to predict events like the Asian crisis.

Third generation models

• Characteristics: focuses on insights from behavioural economics and financial market fragilities, examines how monetary policy affect loan availability and recognises effects of;

  • high short-term debt,

  • asymmetric information,

  • low foreign reserves,

  • and weak banking sectors

• Limitations: monetary policy recommendations are complex and challenging to apply empirically;

  • limiting their practical usefulness for policymakers.