A currency crisis, which is also called a balance-of-payments crisis, is a sudden devaluation of a currency caused by chronic balance-of-payments deficits which usually ends in a speculative attack

Speculative attack

A speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...

 in the foreign exchange market. It occurs when the value of a currency

Currency

In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...

 changes quickly, undermining its ability to serve as a medium of exchange

Medium of exchange

A medium of exchange is an intermediary used in trade to avoid the inconveniences of a pure barter system.By contrast, as William Stanley Jevons argued, in a barter system there must be a coincidence of wants before two people can trade – one must want exactly what the other has to offer, when and...

 or a store of value

Store of value

A recognized form of exchange can be a form of money or currency, a commodity like gold, or financial capital. To act as a store of value, these forms must be able to be saved and retrieved at a later time, and be predictably useful when retrieved....

. Currency crises usually affect fixed exchange rate

Fixed exchange rate

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.A fixed exchange rate is usually used to...

 regimes, rather than floating

Floating exchange rate

A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....

 regimes.

A currency crisis is a type of financial crisis

Financial crisis

The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...

, and is often associated with a real economic crisis. Currency crises can be especially destructive to small open economies

Open economy

An open economy is an economy in which there are economic activities between domestic community and outside, e.g. people, including businesses, can trade in goods and services with other people and businesses in the international community, and flow of funds as investment across the border...

 or bigger, but not sufficiently stable ones. Governments often take on the role of fending off such attacks by satisfying the excess demand for a given currency using the country's own currency reserves or its foreign reserves (usually in the United States dollar

United States dollar

The United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....

, Euro

Euro

The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...

 or Pound sterling

Pound sterling

The pound sterling , commonly called the pound, is the official currency of the United Kingdom, its Crown Dependencies and the British Overseas Territories of South Georgia and the South Sandwich Islands, British Antarctic Territory and Tristan da Cunha. It is subdivided into 100 pence...

).

Recessions attributed to currency crises include the 1994 economic crisis in Mexico

1994 economic crisis in Mexico

The 1994 Economic Crisis in Mexico, widely known as the Mexican peso crisis, was caused by the sudden devaluation of the Mexican peso in December 1994....

, 1997 Asian Financial Crisis, 1998 Russian financial crisis, and the Argentine economic crisis (1999-2002)

Argentine economic crisis (1999-2002)

The Argentine economic crisis was a financial situation, tied to poilitical unrest, that affected Argentina's economy during the late 1990s and early 2000s...

.

Theories

The currency crises and sovereign debt crises

Sovereign default

A sovereign default is the failure or refusal of the government of a sovereign state to pay back its debt in full. It may be accompanied by a formal declaration of a government not to pay or only partially pay its debts , or the de facto cessation of due payments...

 that have occurred with increasing frequency since the Latin American debt crisis

Latin American debt crisis

The Latin American debt crisis was a financial crisis that occurred in the early 1980s , often known as the "lost decade", when Latin American countries reached a point where their foreign debt exceeded their earning power and they were not able to repay it.-Origins:In the 1960s and 1970s many...

 of the 1980s have inspired a huge amount of research. There have been several 'generations' of models of currency crises.

First generation

The 'first generation' of models of currency crises began with Paul Krugman

Paul Krugman

Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

's adaptation of Stephen Salant and Dale Henderson's model of speculative attacks in the gold market. In his article, Krugman argues that a sudden speculative attack

Speculative attack

A speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...

 on a fixed exchange rate, even though it appears to be an irrational change in expectations, can result from rational behavior by investors. This happens if investors foresee that a government is running an excessive deficit, causing it to run short of liquid assets or "harder" foreign currency which it can sell to support its currency at the fixed rate. Investors are willing to continue holding the currency as long as they expect the exchange rate to remain fixed, but they flee the currency en masse when they anticipate that the peg is about to end.

Second generation

The 'second generation' of models of currency crises starts with the paper of Obstfeld (1986). In these models, doubts about whether the government is willing to maintain its exchange rate peg lead to multiple equilibria

Nash equilibrium

In game theory, Nash equilibrium is a solution concept of a game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his own strategy unilaterally...

, suggesting that self-fulfilling prophecies

Self-fulfilling prophecy

A self-fulfilling prophecy is a prediction that directly or indirectly causes itself to become true, by the very terms of the prophecy itself, due to positive feedback between belief and behavior. Although examples of such prophecies can be found in literature as far back as ancient Greece and...

 may be possible, in which the reason investors attack the currency is that they expect other investors to attack the currency.

Third generation

'Third generation' models of currency crises have explored how problems in the banking and financial system interact with currency crises, and how crises can have real effects on the rest of the economy.

McKinnon & Pill (1996), Krugman (1998), Corsetti, Pesenti, & Roubini (1998) suggested that "over borrowing" by banks to fund moral hazard lending was a form of hidden government debts (to the extent that governments would bail out failing banks).

Radelet & Sachs (1998) suggested that self-fulfilling panics that hit the financial intermediaries, force liquidation of long run assets, which then "confirms" the panics.

Chang and Velasco (2000) argue that a currency crisis may cause a banking crisis if local banks have debts denominated in foreign currency,

Burnside, Eichenbaum, and Rebelo (2001 and 2004) argue that a government guarantee of the banking system may give banks an incentive to take on foreign debt, making both the currency and the banking system vulnerable to attack.

Krugman(1999) suggested another two factors, in an attempt to explain the Asian financial crisis: (1) firms' balance sheets affect their ability to spend, and (2) capital flows affect the real exchange rate. (He proposed his model as "yet another candidate for third generation crisis modeling" (p32)). However, in his model, banking system plays no role. His model led to the policy prescription: impose a curfew on capital flight

Capital flight

Capital flight, in economics, occurs when assets and/or money rapidly flow out of a country, due to an economic event and that disturbs investors and causes them to lower their valuation of the assets in that country, or otherwise to lose confidence in its economic...

 which was implemented by Malaysia during the Asian financial crisis.

See also

• Alter-globalization
  Alter-globalization
  Alter-globalization is the name of a social movement that supports global cooperation and interaction, but which opposes the negative effects of economic globalization, feeling that it often works to the detriment of, or does not...
  
  
• ATTAC (Association for the Taxation of Financial Transactions for the Aid of Citizens)
• Central banks - which issue currency
• Currencies
• Currency transaction tax
  Currency transaction tax
  A currency transaction tax is a tax placed on a specific type of currency transaction for a specific purpose. This term has been most commonly associated with the financial sector, as opposed to consumption taxes paid by consumers....
  
  
• Economic collapse
  Economic collapse
  There is no precise definition of an economic collapse. While some might consider a a severe, prolonged depression with high bankruptcy rates and high unemployment an economic collapse, others would additionally look for a breakdown in normal commerce, such as hyperinfalation, or even a sharp...
  
  
• Exorbitant privilege
  Exorbitant privilege
  The exorbitant privilege is a term coined in the 1960s by Valéry Giscard d'Estaing, then the French Minister of Finance.This quote is generally misattributed to Charles de Gaulle, who is said to have had somewhat similar views....
  
  
• Financial markets
• Financial transaction tax
  Financial transaction tax
  A financial transaction tax is a tax placed on a specific type of financial transaction for a specific purpose.This term has been most commonly associated with the financial sector, as opposed to consumption taxes paid by consumers. However, it is not a taxing of the financial institutions themselves...
  
  
• Fluctuation in exchange rates
• Foreign exchange controls
  Foreign exchange controls
  Foreign exchange controls are various forms of controls imposed by a government on the purchase/sale of foreign currencies by residents or on the purchase/sale of local currency by nonresidents.Common foreign exchange controls include:...
  
  
• Foreign exchange market
  Foreign exchange market
  The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
  
  
• Global Justice Movement
  Global Justice Movement
  The Global Justice Movement is a network or constellation of globalized social movements opposing what is often known as the “corporate globalization” and promoting equal distribution of economic resources.-Movement of movements:...
  
  
• Jubilee 2000
  Jubilee 2000
  Jubilee 2000 was an international coalition movement in over 40 countries that called for cancellation of third world debt by the year 2000. This movement coincided with the Great Jubilee, the celebration of the year 2000 in the Catholic Church...
  
  
• Liquidity crisis
  Liquidity crisis
  In financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity In financial economics, liquidity is a catch-all term that may refer to several different yet closely related...
  
  
• Money Market
  Money market
  The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
  
  
• Paul Bernd Spahn
  Paul Bernd Spahn
  Paul Bernd Spahn is emeritus professor of public finance at the Goethe University, Frankfurt am Main, Germany.He was born in Darmstadt, Germany....
  
  
• Spahn tax
  Spahn tax
  A Spahn tax is a type of currency transaction tax that is meant to be used for the purpose of controlling exchange-rate volatility. This idea was proposed by Paul Bernd Spahn in 1995.-Early history:...
  
  
• Speculation
  Speculation
  In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...
  
  
• Speculative attack
  Speculative attack
  A speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...
  
  
• Sudden stop (economics)
  Sudden stop (economics)
  A sudden stop in capital flows is defined as a sudden slowdown in private capital inflows into emerging market economies, and a corresponding sharp reversal from large current account deficits into smaller deficits or small surpluses. Sudden stops are usually followed by a sharp decrease in output,...
  
  
• Speculation in foreign exchange markets
• Tobin tax
  Tobin tax
  A Tobin tax, suggested by Nobel Laureate economist James Tobin, was originally defined as a tax on all spot conversions of one currency into another...
  
  

Related economic crises

• 1994 economic crisis in Mexico
  1994 economic crisis in Mexico
  The 1994 Economic Crisis in Mexico, widely known as the Mexican peso crisis, was caused by the sudden devaluation of the Mexican peso in December 1994....
  
  
• 1997 Asian Financial Crisis
• 1998 Russian financial crisis
• Argentine economic crisis (1999–2002)
• Financial crisis of 2007–2010