Currency crisis analysis based on East Asian countries' experiences: Some macroeconomic implications

The objective of this study is to develop a framework with which to explain the recent currency crisis episodes more fully than can be done with the existing currency crisis theories alone. For more than two decades, the profession's view of balance of payment crises has essentially followed the scenario envisaged by Paul Krugman (1979).; As long as international reserves cannot fall below a critical threshold, any attempt to monetize a given fiscal deficit will lead to a perfectly anticipated speculative attack that depletes the central bank's reserves. The key feature of Krugman-type models implicitly assumes that the central bank sits passively as international reserves dwindle. In practice, however, central banks typically defend pegs aggressively by raising short-term interest rates.; The first part of the study analyzes the feasibility and optimality of raising interest rates to delay a potential balance of payment crisis. A model is set up in which social welfare is shown to be a non-monotonic function of the domestic interest rate: welfare rises with small increases in interest rates but falls beyond a certain point. Income distribution, a previously neglected factor, is also considered in the model. It shows that, if the degree of income inequality is high enough, tightening policy is never effective in defending currency depreciation.; Krugman (1999) admitted that the high capital mobility since the early 1990s caused first- and second-generation currency crisis models based on his earlier work to lose their relevance. He called for a new third-generation model to make sense of the emerging market crises in the late 1990s.; The second part of the study attempts to develop this third-generation approach, for which Krugman proved sketchy direction into a detailed model. This model shows that, under the fixed foreign exchange rate regime, capital inflow tends to appreciate the real exchange rate, which exaggerates the imbalances in current and capital accounts. Once the imbalance exceeds a certain threshold level, it can trigger a self-fulfilling prophecy, reversing current and capital accounts. This process depends on the elasticity of foreign capital with respect to the interest rate.