What is currency crises

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Currency crises

There are three types of currency crises! 

Currency crisis models describe different scenarios and mechanisms through which currency crises can occur. These models, often grouped into "generations," reflect evolving economic thinking about the causes and dynamics of currency crises. Here's a breakdown of the first, second, and third-generation models of currency crises:

### First-Generation Models

- **Concept**:

These models focus on **economic fundamentals** to explain why currency crises occur.

They are based on the idea that governments may maintain a fixed exchange rate despite accumulating macroeconomic imbalances.

- **Key Features**:

When a government runs large budget deficits and funds them through money creation, it can lead to an overvalued currency and inflation. If the market recognizes these imbalances, it can trigger a speculative attack on the currency, leading to a collapse of the fixed exchange rate.

- **Notable Work**:

The classic first-generation model is presented by Krugman (1979), where currency crises are primarily driven by weak fiscal policies and macroeconomic imbalances.

### Second-Generation Models
- **Concept**:

These models extend the analysis by incorporating **self-fulfilling expectations** and **government credibility**. They emphasize that even with stable fundamentals, crises can occur due to shifts in investor sentiment.

- **Key Features**:

In these models, the possibility of speculative attacks arises from investor doubts about the government's commitment to a fixed exchange rate. Governments may abandon the peg not because of immediate economic reasons but because of political or social pressures or the high cost of defending the currency. This uncertainty can lead to a self-fulfilling prophecy, where a speculative attack occurs because investors believe it might.

- **Notable Work**:

The second-generation model is often associated with Maurice Obstfeld's (1994) work, which incorporates factors like government credibility, political costs, and market expectations.

### Third-Generation Models

- **Concept**:

Third-generation models focus on **financial sector vulnerabilities** and **institutional factors** contributing to currency crises. They aim to explain why crises can be more severe and why they spread across countries or regions.

- **Key Features**:

These models highlight the role of financial intermediaries, capital flows, and contagion effects. They suggest that weak financial systems, excessive borrowing in foreign currency, and large capital inflows can increase the risk of crises. These factors can lead to banking crises, which in turn can exacerbate currency crises.

- **Notable Work**:

The third-generation models gained prominence after the Asian financial crisis of the late 1990s. They underscore the interconnectedness of financial and currency crises and stress the importance of robust financial institutions to prevent and manage crises. The contributor is Chang and Velasco in 2011. 

The key difference between the models is their focus on fundamentals, expectations, and financial system vulnerabilities. These models are not mutually exclusive; they can overlap, each addressing different aspects of currency crises.

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