Question

1. What does Krugman’s theory (model) of Currency Crisis state? What is his argument as to what are the causes of a crisis?
2. According to the first generation theory of currency crisis (Krugman) there is one unique equilibrium. What does that mean?

Answer 1

Currency crisis is a situation where in it is doubtful if the central bank of a country has sufficient foreign exchange reserve available to maintain it's fixed exchange rate. It is also called as balance of payment crisis. The first generation of currency crisis analysis began with studies of Paul Krugman, where he argues argues that a 'sudden speculative attack 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 an investor sees that the government is running huge deficit and running short of liquid assets and foreign exchange which can be sold to manage the exchange. In this case, investors will be willing to hold the currency as long as the exchange rate is fixed and they flee the currency in bulk when they anticipate the peg to end.