Exchange Rate Economics: Theories and Evidence

324 Speculative attack models and contagion
of government guarantee (either explicit or implicit). In this kind of scenario the
financial intermediaries are able to borrow at low (government backed/linked)
interest rates and lend at relatively high rates in risky investment projects. By
inflating the price of these risky assets the intermediaries inflate the asset side of
their balance sheets which provokes further lending: a classic bubble process arises
and when it eventually bursts produces capital flight and sparks a currency crises
(see,for example,Corsetti et al. 1998 and Edison et al. 1998).
Krugman’s (1999) variant of the third generation model focuses on a balance
sheet approach. In particular,he considers highly leveraged firms holding a large
proportion of foreign currency-denominated-debt. If there is then an exogenous
capital outflow which results in a currency depreciation which if it is large enough
can eliminate the net worth of firms. In imperfect capital markets firms with poor
balance sheets cannot invest and so real investment collapses,thereby validating
the capital flight. Krugman illustrates this view using a simple variant of the
Mundell–Fleming model. The aggregate demand,money market and UIP conditions
are given here,respectively,as expressions (13.21) to (13.23) and should be
self-explanatory given our discussions in previous chapters.
y = D(y, i) + NX (sP ∗ /P, y),(13.21)
M /P = L(y, i),(13.22)
i = i ∗ . (13.23)
The graphical solution to this simple model is given in Figure 13.4,where
GG shows how output is determined given the exchange rate and money market
equilibrium is represented by the schedule AA. The GG schedule is upward
sloping because an exchange rate depreciation increases net exports which,in turn,
increases output. The AA schedule indicates all points at which (13.23) satisfied,
s
A
G
X
G
A
y
Figure 13.4 Base line MF model.