Interdependent Expectations and the Spread of Currency Crises

In this paper we analyze how the mutual interdependence of private sector expectations influences the stability offixed exchange rate regimes in different countries. When countries trade with one another, the crisis probabilities are interdependent because monetary policy in each country affects welfare both at home and abroad. Wage setters react to a trading partner's imminent crisis, because a loss of international competitiveness changes their governments' optimal escape clauses. Thus, not only actual devaluations but an increasing crisis probability in one country may trigger currency crises elsewhere. We show that both fundamental weakness and spontaneous shifts in market sentiment may play a role in the transmission of currency crises.