The Causes and Consequences of a Currency Crisis Essay

The Causes and Consequences of a Currency Crisis - Essay Example This creates inflation and a current account deficit, which may lead investors to doubt the exchange rate peg. Speculators eventually mount an attack--that is, they demand foreign reserves in exchange for the domestic currency. To defend the peg, the monetary authorities sell off foreign exchange reserves. When the reserves fall to a certain point, the government is faced with a choice: should it break its external promise (to keep the exchange rate fixed) or keep its internal political constituents happy (by not raising taxes or cutting spending) Governments usually choose internal objectives over external constraints; that is, there is a currency crisis. A model like this works well in helping to understand the breakdown of inflationary economies, like Russia in 1998. But such models don't help understand recent crises in Asia. Most Asian countries had admirable monetary and fiscal policies that were viewed as being sustainable. The second model views currency crises as shifts between different monetary policy equilibria; here speculative attacks can be self-fulfilling even against countries with sound policies. In these models, market speculators initiate attacks based on their beliefs about the willingness of policymakers to resist pressure on the exchange rate. When markets perceive that conditions, such as high unemployment or a weak banking system, compromise the central bank's willingness to defend the currency peg by raising interest rates, speculative attacks are more likely to succeed. When a country faces a currency crisis, other countries are affected mainly because of international trade. Thailand faced a financial crisis which led to Malaysia and Indonesia's currency situation as these countries were Thailand's main trade competitors. Hence, trade is regional so currency crises are regional. Recessions are associated with currency crises and Last Name 3 lead to a fall in imports. Trade flows are disrupted as one country's imports fall causes another country's exports to decrease. Once trade flows are disrupted, major issues occur as free trade is a wonderful thing. There are many models that attempt to explain the phenomenon of how a financial crisis is formed. Chang and Velasco (1998) suggest a useful model should consist of the following features, "It must not rely on government misbehavior to generate the crisisIt must be general enough to accommodate a wide variety of macroeconomic circumstancesIt must be specific enough to explain why in some of these macroeconomic scenarios a crisis occurs, and in some it does notIt must account for the high observed correlation between exchange rate collapses and banking crisesIt must replicate the puzzling fact that the punishment is much larger than the crime" The transferring of information in international financial markets can cause most of the information to become trapped. Minute changes in information can cause incredible behaviour by international investors. During a currency crisis, governments tend to expropriate foreign funds in an attempt to raise funds. (Chari and Kehoe, 1997). Their model implies that only governments with weak reputations are subject to volatile capital flows. Thailand faced incredible external (foreign) debts. As its debts increased, creditors wondered if it could meet its obligations. Hence, supply