Abstract
We develop a model in which government guarantees to banks' foreign creditors are a root cause of self-fulfilling twin banking-currency crises. Absent guarantees, such crises are not possible. In the presence of guarantees banks borrow foreign currency, lend domestic currency and do not hedge the resulting exchange rate risk. With guarantees, banks will also renege on their foreign debts and declare bankruptcy when a devaluation occurs. We assume that the government is unable or unwilling to fully fund the resulting bailout via an explicit fiscal reform. These features of our model imply that government guarantees lead to self-fulfilling banking-currency crises.
Original language | English (US) |
---|---|
Pages (from-to) | 31-63 |
Number of pages | 33 |
Journal | Journal of Economic Theory |
Volume | 119 |
Issue number | 1 |
DOIs | |
State | Published - Nov 1 2004 |
Funding
$This paper was previously circulated under the title ‘‘On the Fundamentals of Self-Fulfilling Speculative Attacks.’’ We gratefully acknowledge grants from the National Science Foundation through the NBER, financial support from Kellogg’s Banking Research Center, and the Hoover Institution for a National Fellowship. The opinions in this paper are those of the authors and not necessarily those of the Federal Reserve Bank of Chicago. We are thankful to Larry Christiano and Olivier Jeanne for their comments.
Keywords
- Debt denomination
- Fixed exchange rate regimes
- Government guarantees
- Hedging
ASJC Scopus subject areas
- Economics and Econometrics