International macroe.. - Free

Chapter 11Balance of Payments CrisesIn chapter 10 we argued that there is a presumption that any Þxedexchange rate regime must eventually collapse–a presumption that thedata supports. Britain and the U.S. were forced off of the gold standardduring WWI and the Great Depression. More recent collapsesoccurred in the face of crushing speculative attacks on central bank reserves.Some well-known foreign exchange crises include the breakdownof the 1946—1971 IMF system of Þxed but adjustable exchange rates,Mexico and Argentina during the 1970s and early 1980s, the EuropeanMonetary System in 1992, Mexico in 1994, and the Asian Crisis of 1997.Evidently, no ÞxedexchangerateregimehasevertrulybeenÞxed.This chapter covers models of the causes and the timing of currencycrises. We begin with what Flood and Marion [57] call Þrst generationmodels. This class of models, developed to explain balance of paymentscrises experienced by developing countries during the 1970s and1980s. These crises were often preceded by unsustainably large governmentÞscal deÞcits, Þnanced by excessive domestic credit creationthat eventually exhausted the central bank’s foreign exchange reserves.Consequently, Þrst-generation models emphasize macroeconomic mismanagementas the primary cause of the crisis. They suggest that thesizeofacountry’sÞnancial liabilities (the government’s Þscal deÞcit,shorttermdebtandthecurrentaccountdeÞcit) relative to its short runability to pay (foreign exchange reserves) and/or a sustained real appreciationfrom domestic price level inßation should signal an increasinglikelihood of a crisis.327