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THE ROLE OF CREDIBILITY IN DETERRING SPECULATIVE ATTACKS MODELS OF CURRENCY CRISIS

Paul Krugman developed the first analytical model of balance-of- payments
crises in 1979. He argued that crises occur when a continuous deterioration in the
economic fundamentals becomes inconsistent with an attempt to fix the exchange
rate1. Krugman’s model identifies excessive domestic credit creation either to finance
fiscal deficits or to provide assistance to a weak banking system as the original
problem. More specifically, his model assumes that the government does not have
access to capital markets and therefore has to monetize its expenditures. This increase
in the quantity of money in the economy tends to reduce domestic interest rates. Since
world interest rates have not changed, this induces capital outflows and a gradual loss
of foreign exchange reserves. Further down the road, the economy eventually
becomes the victim of a speculative attack that triggers the abandonment of the fixed
exchange rate system. In the model, a critical level in the amount of reserves
determines the timing of the attack. The fall of reserves to this threshold induces
speculators to exhaust the remaining reserves in a short period of time to avoid capital
losses. The Krugman model and its extensions represent what has become known as
first-generation models of balance-of- payments crises2. The main insight of these
models is that crises arise as a result of an inconsistency between domestic policies
(i.e. excessive public spending that becomes monetized) and a fixed exchange rate. In
this sense, a crisis is both unavoidable and predictable in an economy with a constant
deterioration of its economic fundamentals3.
Krugman’s model of the inevitable abandonment of an unsustainable peg was
a major step in understanding how currencies collapse, and it spawned a large
literature. Blackburn and Sola4 present a summary of first-generation models of this
type. Drazen and Helpman5 study the implications of mutually inconsistent monetary, fiscal, and exchange rate policies more generally, in that policy changes other letting
the exchange rate float are considered in response to the inconsistency. In the latter
paper the emphasis is on the effects of uncertainty about the date of policy change.
The basic speculative attack model considered in these papers assumes passive policy
makers. In the original Krugman model, for example, the behavior of policy makers is
transparent. They stick with current mutually inconsistent policies and abandon the
fixed rate reflexively when the critical minimum level is reached. They neither take an
aggressive role in defending the current exchange rate policy, nor do they adjust their
commonly known policy objectives in light of external economic and political
developments6. Understanding currency crises therefore requires modeling the
optimizing behavior of government, in which its conflicting objectives and how they
are weighted are modeled explicitly.

1 Krugman, Paul.. “A Model of Balance of Payments Crises.” Journal of Money, Credit and Banking 11 (August1979).
2 Extensions to the Krugman model have been developed by Flood and Garber (1984) and Conolly and Taylor (1984). More
recently, Krugman (1991) extended the analysis to a target zone model. Flood, Garber and Kremer (1996) incorporate the role of
sterilization into the analysis. For a survey of these models see Agenor, Bhandari and Flood (1992).
3 As Krugman (“Are Currency Crises Self-Fulfilling?” NBER Macroeconomics Annual, 345-78.1996) and others have pointed
out, the classical model of currency crises is based on the paper by Salant and Henderson (1978), who showed that the attempt to
peg the price of gold based on a government-held stock would collapse with a speculative attack that wipes out that stock.
4 Blackburn, Keith and Martin Sola (1993), “Speculative Currency Attacks and Balance of Payments Crises,” Journal of
Economic Surveys 7, 119-44.

5 Drazen, Allan and Elhanan Helpman “Stabilization with Exchange Rate Management,” Quarterly Journal of Economics 52.
(1987)
“Stabilization with Exchange Rate Management under Uncertainty,” in Economic Effects of the Government Budget,
Cambridge, MA: MIT Press. (1988)
6 In the Drazen and Helpman papers, other policies can be adjusted, but there is no government optimization which determines
which policies to change. Ozkan, F. Gulcin and Alan Sutherland in the“Policy Measures to Avoid a Currency Crisis” – Economic
Journal 105, 510-19. (1995) – present an optimizing model of policy changes to avoid a currency crisis.

BIBLIOGRAPHY:
 Blackburn, Keith and Martin Sola (1993), “Speculative Currency Attacks and
Balance of Payments Crises,” Journal of Economic Surveys 7, 119-44.
 Drazen, Allan and Elhanan Helpman “Stabilization with Exchange Rate
Management,” Quarterly Journal of Economics 52. (1987)
 Drazen, Allan and Elhanan Helpman “Stabilization with Exchange Rate
Management under Uncertainty,” in Economic Effects of the Government Budget,
Cambridge, MA: MIT Press. (1988)
 Krugman, Paul. “A Model of Balance of Payments Crises.” Journal of Money,
Credit and Banking 11 (August1979).
 Krugman, Paul. “Are Currency Crises Self-Fulfilling?” NBER Macroeconomics
Annual, 345-78. (1996).
 Ozkan, F. Gulcin and Alan Sutherland “Policy Measures to Avoid a Currency
Crisis” – Economic Journal 105, 510-19. (1995).