Explaining currency crises

There are three main theories that explain currency crises. They are called the first, second, and third generation models of currency crises due to the timing of their development.

The first generation model was developed in the late 1970’s and attributes crises to fundamental policy problems.

The second generation model came into being during the 80’s. In that model, the fundamentals of the economy are relatively fine but a speculative attack may trigger a crisis.

The third generation model was developed in response to the Asian financial crisis of 1997. Here too the fundamentals of the economy are fine but the country cannot meet its short-term debt obligations. That is a liquidity crisis.

Each of these models can explain different crises. However, it is very difficult to put the correct diagnosis on an unfolding crisis: is it a first, second or third generation type or a mix? Too many things are happening very fast: the currency is plummeting, the government is in disarray, prices are increasing rapidly, the economy is contracting. There is much disagreement about the appropriate response to the crisis. In a few years, then the dust settles down, we can assess better the type of the crisis.

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