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A currency crisis is a situation in which there is serious doubt as to whether a
country's central bank has enough foreign exchange reserves to maintain the
country's fixed exchange rate. The crisis is often accompanied by a speculative
attack in the foreign exchange market. A currency crisis results from chronic
balance of payments deficits, and thus is also called a balance of payments
crisis. Often such a crisis culminates in a devaluation of the currency.
A currency crisis is a type of financial crisis, and is often associated with a real
economic crisis. Currency crises can be especially destructive to small open
economies or bigger, but not sufficiently stable ones. Governments often take
on the role of fending off such attacks by satisfying the excess demand for a
given currency using the country's own currency reserves or its foreign reserves
(usually in the United States dollar, Euro or Pound sterling). Currency crises
have large, measurable costs on an economy, but the ability to predict the
timing and magnitude of crises is limited by theoretical understanding of the
complex interactions between macroeconomic fundamentals, investor
expectations, and government policy.
There is no widely accepted definition of a currency crisis, which is normally
considered as part of a financial crisis. Kaminsky et al. (1998), for instance,
define currency crises as when a weighted average of monthly percentage
depreciations in the exchange rate and monthly percentage declines in exchange
reserves exceeds its mean by more than three standard deviations. Frankel and
Rose (1996) define a currency crisis as a nominal depreciation of a currency of
at least 25% but it is also defined at least 10% increase in the rate of
depreciation. In general, a currency crisis can be defined as a situation when the
participants in an exchange market come to recognize that a pegged exchange
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rate is about to fail, causing speculation against the peg that hastens the failure
and forces a devaluation or appreciation, see Al-Assaf et al. (2013).
Recessions attributed to currency crises include the 1994 economic crisis in
Mexico, 1997 Asian Financial Crisis, 1998 Russian financial crisis, and the
Argentine economic crisis (1999-2002).
Theories
The currency crises and sovereign debt crises that have occurred with increasing
frequency since the Latin American debt crisis of the 1980s have inspired a
huge amount of research. There have been several 'generations' of models of
currency crises.
First generation
The 'first generation' of models of currency crises began with Paul Krugman's
adaptation of Stephen Salant and Dale Henderson's model of speculative attacks
in the gold market. In his article, Krugman argues that a sudden speculative
attack on a fixed exchange rate, even though it appears to be an irrational
change in expectations, can result from rational behavior by investors. This
happens if investors foresee that a government is running an excessive deficit,
causing it to run short of liquid assets or "harder" foreign currency which it can
sell to support its currency at the fixed rate. Investors are willing to continue
holding the currency as long as they expect the exchange rate to remain fixed,
but they flee the currency en masse when they anticipate that the peg is about to
end.