The second generation model of currency crises

In the second generation model of crises, the economy has a fixed exchange rate regime. However, it does not have fundamental problems such as a large fiscal deficit, a large current account deficit, or high inflation. Then, for no apparent reason, currency traders “attack” the currency, i.e. they start to sell it in large amounts. How should the authorities react? Their immediately available weapon of defense is to raise interest rates.

Option 1. Raise interest rates to stop the traders from selling the domestic currency. The high interest rates motivate traders to keep their money in the domestic currency as it gives them a higher return. However, the high interest rates put pressure on households and firms that have borrowed money. If interest rates increase a lot, everyone cuts their purchases and the economy enters a recession.

Option 2. Keep interest rates unchanged and avoid a recession. In that case, however, investors keep fleeing and the currency devalues.

Therefore, the choice is recession or devaluation. Put into that situation, many governments prefer devaluation. Notice that the devaluation happens only because the currency traders started selling the currency. Otherwise, there would be no problem. Hence, these types of crises have no warning signs. Something could trigger the sell-off and the devaluation becomes a self-fulfilling prophecy.