Government Budget, Oil Prices and Currency Crisis in Russia

Abstract

We present a crisis model which illustrates how oil price shocks led to the resulting collapse of the fixed exchange rate system in Russia. We discuss crucial weaknesses of the Russian economy and argue that the reason it was particularly vulnerable to shocks was that the government and the energy sector were very closely linked. In the model presented an optimizing policymaker abandons a fixed exchange rate regime because he wants to tighten fiscal policy and finance a deteriorating budget deficit. Agents in the foreign exchange market know the policy maker’s objective function and build expectations of a regime switch into interest rate differentials. The resulting rise in interest rates affects the policy maker’s decision to switch the regime. We show that a rational expectations equilibrium exists where it is optimal to abandon the fixed exchange rate regime.

Keywords: currency crisis, speculative attack, rational expectations equilibrium

JEL Classification: E43, F31, F32, P33