The first generation model of currency crises

According to that explanation, currency crises have a fundamental cause. They are not the result of bad luck or market speculation but of bad policy. Here is how the story goes:

The government pursues two policies at the same time: 1) maintain a fixed exchange rate regime and 2) print money to run large budget deficits. The problem is that the two policies are inconsistent with each other and cannot both be maintained for very long.

Printing money leads to high inflation which makes domestic products less competitive compared to imports. The country begins to run large trade deficits. Notice on the chart the large trade deficits of Mexico leading up to its 1994 devaluation.


To finance the trade deficits, the country has to attract foreign investment. Notice on the next chart how much money was flowing into Mexico while it ran the trade deficit.
At some point, of course, the party is over and foreign investors are not willing to finance Mexico any more. Then, the country has to let go of its fixed exchange rate and the currency devalues. Domestic production becomes more competitive internationally. Exports increase, imports decline, and the trade deficit is eliminated as you can see in the first chart. The balance is restored.


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