Exchange Rate Economics: Theories and Evidence

13 The economics of fixed
exchange rates, part 2
Speculative attack models
and contagion
In this chapter we overview the speculative attack and currency crises literatures.
The speculative attack models were originally developed to provide an understanding
of currency crisis in Latin America and,in particular,the failure of stabilisation
plans in the 1970s and 1980s. The so-called first generation models of Krugman
(1979) and Flood and Garber (1984) had at their core the relationship between a
fixed exchange rate and inconsistent economic fundamentals,namely,monetary
and fiscal policy. In particular,this class of model was designed to show how a
combination of fixed exchange rates and excessive money supply growth prior to
an attack could push an economy into crises,with the private sector trying to profit
from unravelling what they see as inconsistent policies. An alternative perspective
on this class of models is to say they demonstrate that currency crises associated
with the stabilisation policies pursued in Latin America in the 1970s and 1980s
were not a sign of market malfunction,but rather they are the consequence of
an inappropriate fiscal–monetary mix pursued by these countries (Jeanne 2000a).
A classic application of the first generation model has been to the devaluation of
the Mexican peso in 1976 and 1981 (see Blanco and Garber 1986).
However,first generation models are not regarded as particularly well-suited to
explaining the behaviour of the Mexican peso in the 1990s and the ERM crisis
in 1992–3. In the latter,countries such as France and the UK had pursued a
sound monetary–fiscal mix but were nevertheless spectacularly ejected from the
ERM arrangement. How may such crises be explained? The so-called second
generation models of Obstfeld (1994) and Flood and Marion (1997b,2000) were
designed to tackle these kind of crises. 1 They have two features which distinguish
them from first generation models: first,they have a much richer specification
of what is a fundamental and this can,in the limit,involve any variable which
influences the policy-maker’s decision to defend a peg or not. This can include
‘hard’ fundamentals,such as unemployment,and ‘soft’ fundamentals,such as the
beliefs of foreign exchange market participants (Jeanne 2000). The latter kind of
fundamental leads into the second contribution of these models,namely,that they
provide a new theory of self-fulfilling speculation and multiple equilibria. The
latter feature of these models is designed to show how a speculative attack may
apparently be unrelated to fundamentals.