Question

Compare and contrast the different theoretical models that attempt to explain currency crises. Focus on the first, second, and third generation models bringing in examples from real financial crises that can help you to explain the similarities and differences between the three types of models.

Answer 1

Answer :-

A currency crisis is a speculative attack on the foreign exchange value of a currency, creating doubt on sufficiency of foreign exchange reserve with Central Bank to maintain fixed exchange rate. Currency crises have large measurable costs on the economy.In other words it can be defined as decline in currency or international reserves or combination of both.

First Generation Model - This model explain that a currency crisis will result if government has huge deficit and there is fixed exchange rate. The monetization will result in high inflation and it leads to foreign outflow and speculative attack on domestic currency. This attack could initially defend by forex reserves but if the attack is severe or increases it will result in devaluation. A sudden devaluation of Fixed exchange rate leads the collapse of exchange rate system and it lead to crisis.

Second Generation Model - In First generation models, Government and Central bank behaviour is not fully rational.First Generation model could not explain contagious currency crisis. The Second Generation model explains this events via trade channels or via neighbouring trade partners or via financial channels.

Third Genration Model - First G and Second G did not provide policy prescription. First G model actually says crisis cannot be thwarted once expectation of devaluation sets in.Typical prescription for a currency crisis is to raise interest rates and prevent capital outflows. However, Third G model says a currency crisis leads to number of problems in the economy and higher interest rates would create more damage to the economy. The 3 G models instead suggest to keep real interest rates low and keep financial system functioning in the crisis (make banks give credit etc).

Real Financial Crisis Instances -

1. We saw South East Asian Crisis becoming a contagious crisis spreading from one region to other. Here the first G model failed as First Generation model could not explain contagious currency crisis but second G model worked out.

2. Third G Model developed after the Asian crisis of 1997 as the First and Second G models were not able to predict it although the economic fundamentals were sound at that time.

3. Global Financial Crisis of 2007-08 was the worst economic disaster since the stock market crash of 1920 and it expanded to global banking crisis with failure of investment bank Lehman Brothers in September 2008.

Basis	First G	Second G	Third G
Main Creators	P. Krugman, P. Garber, R.Flood	M Obstfeld, A. Calvo A. Rose A. Velasco S Morris	A. Rose B. Eichengreen M Obsfteld
Main Economic Indicators	Fiscal Deficit/GDP, Real money quantity,	Import, Export,Real Exchange Rate,Trade terms, real interest rate	Domestic credit/ International GDP,Deposits, share price, bankng crisis
Main Properties	Focus on long run Unique Equilibrium Govt Deficit Monetization is the main cause of speculation attack against national currency.	Focus on short run Multiple Equilibrium Crisis depends on speculators expec-tation	This model already allow to establish how monetary policy can impact the currency crisis and to explain the causes why crisis spread across the countries.
Similarities	(1) In first and second G is based on notion of speculation, both suggest 'speculation' as its drivers. Also, the collapse of echange rate regime is fundamental-driven in both models. (2) The 3 models together provides following factors that lead to a currency crisis- Domestic Public and Private debt · Expectations · State of financial markets · Pegged exchange rate