The Other Twins: Currency and Debt Crises

37 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

Date Written: January 2003

Abstract

Empirically, currency crises are more frequently accompanied by simultaneous sovereign debt crises than by banking crises. Nevertheless the phenomenon of twin currency and debt crises has so far been treated in economic literature only sparsely. We analyse 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 parameters have a large impact not only on the public welfare but on the government's budget as well. The resulting incentive system can generate situations with self-fulfilling expectations. In some situations an internal contagion effect 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.

Keywords: currency crises, internal contagion, self-fulfilling expectations and sovereign debt

JEL Classification: E61, F34, F41

Suggested Citation

Herz, Bernhard and Bauer, Christian and Karb, Volker, The Other Twins: Currency and Debt Crises (January 2003). Available at SSRN: https://ssrn.com/abstract=1002594 or http://dx.doi.org/10.2139/ssrn.1002594

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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