Fiscal Deficits and Currency Crises

Abstract

This paper investigates currency and financial crises in an optimizing general equilibrium model. It is shown that a rise in current and expected future budget deficits generates a real exchange rate appreciation and a decumulation of external assets, leading up to a currency crisis when foreign reserves approximate a critical level. Strong empirical support for our model is obtained by a probit estimation for Latin American and Asian countries.

Keywords: budget deficits, foreign exchange reserves, currency crises

JEL Classification: F31, F32, F41, E52, E62