url
13
Aug
2014

ASIAN CURRENCY CRISIS: Introduction 2


While not modeled in this paper, raising distortionary taxes or lowering government purchases under those circumstances could well be politically unacceptable or socially undesirable relative to the alternative: monetizing the prospective deficits and receiving aid from international agencies like the International Monetary Fund. But this alternative is incompatible with maintaining fixed exchange rates. In this sense, our view of recent events in Southeast Asia is related to ‘second generation’ speculative attack models which stress that governments consider the costs and benefits of abandoning fixed exchange rate regimes.

To articulate our view of the Southeast Asian currency crisis, sections 2 and 3 of the paper study the dynamics of a speculative attack in a variant of the perfect foresight small open economy model considered by Calvo (1987). The key difference between our model and Calvo’s is the nature of the monetary experiment that we analyze. To capture the effect of a prospective deficit on a fixed exchange rate regime we assume that at time 0 agents receive information that future deficits will be larger than they originally believed so.

The government’s intertemporal budget constraint implies that a speculative attack is inevitable. This is true regardless of the government’s initial level of foreign reserves or its initial debt position. Once the government learns that the present value of future deficits has risen, the only choices left to it are when and how to raise the seignorage revenues required to meet its intertemporal budget constraint.

We analyze the date of a speculative attack, i.e. the date at which the economy switches from a fixed to a floating exchange rate regime, under two assumptions. First, we assume that the government follows a threshold rule according to which the fixed exchange rate regime is abandoned in the first period that net government debt reaches some exogenous upper bound. Second, we consider the case in which the only constraint faced by the government is its intertemporal budget constraint.

Using versions of the model calibrated to Korean and Thai data, we show in Section 4 that the speculative attack occurs after the information about higher future deficits arrives but before the new monetary policy is implemented. An econometrician looking at the data would see an exchange rate crisis – but he would not see large deficits, low levels of reserves, high growth rates of money or high rates of inflation prior to the speculative attack. The econometrician could well conclude that the attack was a multiple equilibrium phenomenon. In fact it reflects fundamentals: high prospective deficits.

While the government cannot prevent a speculative attack, it can affect its timing by borrowing. The cost of delaying is higher future inflation once the speculative attack takes place. This raises the issue of what monetary policy the government should pursue.

While not modeled in this paper, raising distortionary taxes or lowering government purchases under those circumstances could well be politically unacceptable or socially undesirable relative to the alternative: monetizing the prospective deficits and receiving aid from international agencies like the International Monetary Fund. But this alternative is incompatible with maintaining fixed exchange rates. In this sense, our view of recent events in Southeast Asia is related to ‘second generation’ speculative attack models which stress that governments consider the costs and benefits of abandoning fixed exchange rate regimes. To articulate our view of the Southeast Asian currency crisis, sections 2 and 3 of the paper study the dynamics of a speculative attack in a variant of the perfect foresight small open

About The Author

Kevin J. Brandon

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