Another Twin Crisis: Currency and Debt Crisis

Review in Economics, Vol. 54, No. 3, pp. 248-267, 2003

36 Pages Posted: 24 Jul 2007

See all articles by Bernhard Herz

Bernhard Herz

University of Bayreuth

Christian Bauer

University of Trier; Universität Trier

Volker Karb

University of Bayreuth

Abstract

Empirically, currency crises are more frequently accompanied by sovereign debt crises than by banking crises. Nevertheless the phenomenon of twin currency and debt crises has so far been neglected in economic literature. We analyze the optimal policy of a government that may choose and combine two policy alternatives. She may choose at the same time whether to keep or alternatively exit an existing exchange rate peg and whether or not to default on her debt. Both a devaluation and a default can be used to finance public expenditure. In addition both parameters have a large impact on the public welfare. The resulting incentive system can generate situations with self-fulfilling expectations. In some situations an internal contagion e.ect arises. A crisis in the sovereign debt market spreads to the sector of exchange rate policy and causes a devaluation as well. Private investors' default expectations thus can not only cause a sovereign debt crisis but may lead to a currency crisis as well.

JEL Classification: F34, F41, E61

Suggested Citation

Herz, Bernhard and Bauer, Christian and Karb, Volker, Another Twin Crisis: Currency and Debt Crisis. Review in Economics, Vol. 54, No. 3, pp. 248-267, 2003, Available at SSRN: https://ssrn.com/abstract=1002536

Bernhard Herz (Contact Author)

University of Bayreuth ( email )

Universitatsstr 30
Bayreuth, D-95447
Germany

Christian Bauer

University of Trier ( email )

15, Universitaetsring
Trier, 54286
Germany

Universität Trier ( email )

Germany

Volker Karb

University of Bayreuth ( email )

Universitatsstr 30
Bayreuth, D-95447
Germany

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