Financial Crises, Monetary Policy and Financial Fragility; A Second-Generation Model of Currency Crises

In this Paper we present a model that combines the second-generation trade-off between costs of maintenance and abandonment with possible balance-sheet problems in the corporate sector. We show how debt levels can move a small economy from a fixed exchange rate to a floating exchange rate equilibrium or vice versa, simply by altering the trade-off faced by the monetary authorities. Even if the monetary authorities still have a substantial amount of foreign reserves available to guarantee the fixed value of the currency, they might choose not to and abandon the fixed exchange rate regime. Although it is often argued that first- and second-generation literature have not been able to explain the crisis in East Asia (1997-98), our model suggests that adding corporate balance sheet positions to second-generation models could substantially improve the explanatory power of these models in the case of the Asian crisis.