Output, Interest Rate & Exchange Rate (Mundell–Fleming)

Currency & Sovereign Crises

extensionExam · medium

Fixed exchange rates are vulnerable to speculative attack. First-generation (Krugman 1979): inconsistent fiscal/monetary fundamentals exhaust reserves → peg collapses. Second-generation (Obstfeld 1994): multiple equilibria — self-fulfilling attack even with sustainable fundamentals if CB defends at too-high a cost. Third-generation: balance-sheet and banking-crisis interactions (Asia 1997).

Derivation

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Three Generations

| Gen | Main driver | Example | |-----|-------------|---------| | 1st (Krugman 1979) | Fiscal → monetary | Mexico 1976, Argentina 1978 | | 2nd (Obstfeld 1994) | Self-fulfilling | ERM 1992 (UK, Italy) | | 3rd (balance sheet) | FX mismatches + banking | Asia 1997–98 |

First-Generation

If a country finances deficits by printing money while pegging FX, reserves decline. Eventually, agents anticipate collapse and attack earlier — the speculative attack timing is determined by the shadow exchange rate equalling the peg.

Second-Generation

Even with okay fundamentals, a peg can break via self-fulfilling attack:

The CB chooses whether to defend or abandon. If markets expect abandonment, they attack; if the attack forces the CB's cost of defending above the cost of abandoning, the CB complies. Rational multiple equilibria.

Third-Generation

Private-sector currency mismatches amplify crises:

Firms borrow in USD (low US rates) but earn in local ccy.
Peg breaks → large depreciation → USD liabilities soar in domestic ccy terms.
Mass bankruptcies → banking crisis → credit crunch → deeper recession.

Asia 1997: Thailand, Korea, Indonesia, Malaysia. GDP fell 5–15%.

Policy Responses

| Tool | Effect | |------|--------| | Reserve accumulation | Raises attack cost | | Capital controls | Blocks outflows (Malaysia 1998) | | CB backstop (ECB OMT) | Removes self-fulfilling equilibrium | | Currency board | Hard peg via legal rigidity | | Float | Crisis avoided, FX volatility accepted |

Bipolar View

After the 1990s, the economics profession converged on the view that intermediate pegs are unstable. Countries should pick corner solutions: hard peg (Hong Kong, Bulgaria) or full float (Brazil, UK). Crawling pegs and managed floats tend to fail.

Worked Example

Country with fixed peg at E = 1.0 local/USD. Reserves R₀ = 10 billion. Monetary financing creates money at 10%/year. Post-peg E would be 1.2.

Reserves decline at ≈ 1 billion/year under peg defence.
Linear decline: R = 10 − 1·t. Reserves hit zero at t = 10 years.
But agents anticipate — shadow rate = 1.2. When shadow > peg, attack now.
Empirically, collapses come faster than naive reserves calculation suggests.

Peg collapses before reserves formally exhaust — speculative attack triggered as soon as shadow rate exceeds peg. This is the peso-problem / 1992 EMS pattern.

Common Mistakes

—Assuming crises are only about fundamentals — second-generation self-fulfilling crises don't require weak fundamentals.
—Confusing currency crisis (FX peg breaks) with banking crisis (banks insolvent) — they can occur together (third-generation) or separately.
—Missing the bipolar corner-solution argument — intermediate pegs are unstable.
—Ignoring capital controls as a policy response — unpopular but effective in some cases.

Exam Cues

→Three generations: Krugman (fundamentals), Obstfeld (self-fulfilling), Asian (balance-sheet).
→Fixed FX + deficit monetisation = eventual collapse. Attack timing accelerated by anticipation.
→Self-fulfilling attacks: CB abandons if defence cost > abandonment cost. Multiple equilibria.
→Bipolar view: corner solutions (hard peg or full float) dominate intermediate fixed regimes.