Exchange Rate Economics: Theories and Evidence

314 Speculative attack models and contagion
The Latin American and Asian crises of 1995 and 1997 do not seem well
explained by the second generation models. For one thing,if the second generation
models are correct the abandonment of a fixed peg should allow a country
more expansionary macroeconomic policies. However,in the aftermath of the
Latin American and Asian crises countries faced severe recessions. Two strands
have developed in the speculative attack literature to explain these kind of crises:
one is based on a moral hazard argument and the other is based on bank runs
producing a currency crisis. These two contributions have been grouped under
the label third generation models.
The outline of the remainder of this chapter is as follows. In the next section
we discuss the variants of the speculative attack model,ranging from the first
generation model to the escape clause model and the third generation model. In
Section 13.2 the empirical evidence on the theoretical models is overviewed and
this incorporates a review of the recent literature on contagion.
13.1 The theoryof a speculative attack
13.1.1 First generation models
The standard first generation model is based on a small open economy with perfect
capital mobility and a fixed exchange rate (see Krugman 1979 and Flood and
Garber 1984). 2 As in other small open economy models considered elsewhere
in this book this implies that the country takes foreign interest rates and prices
as parametrically given. It is important to note that in this class of model the
monetary policy instrument is domestic credit,rather than the interest rate or the
total quantity of money. Additionally,this choice of monetary variable means that
monetary and fiscal policy may be interrelated,to the extent that domestic credit
evolves in response to fiscal deficits. The money market equilibrium condition is
given by a simplified form of the log-linear money demand function first introduced
in Chapter 4:
m − p =−α(i), α > 0,(13.1)
where symbols have the same interpretation as before and the domestic money
supply can be decomposed into two central bank assets: d,domestic credit and r,
international reserves:
m = d + r. (13.2)
PPP is assumed to hold continuously:
p = p ∗ + s. (13.3)
The assumption of perfect capital mobility is described here by the UIP condition,
in which the expected change in the exchange rate has been replaced by the actual