A Model of Balance of Payments Crisis: Monetary Independence as a Determinant of Exchange Rate Disequalibria

What factors determine a government's decision to abandon a currency peg or to continue to use a fixed exchange rate? This question may be logical when one recognizes that governments can borrow international reserves and exercise other policy options to defend fixed exchange rates during currency crises. When the government initiates purposeful actions, the possibility of self-fulfilling crises and multiple equilibria become important. Speculative responses depend on anticipated government responses, which in turn, depend on how price changes affect the government's economic and political positions. This circular flow pattern implies the potential for crises that need not occur, but occur because market participants expect them to occur. This paper presents a model in which crisis and realignment result from the domestic government's fiscal, monetary and economic policies. If these policies are not consistent with the exchange rate regime and based on sound macroeconomic fundamentals, the currency peg can become untenable.