The Nexus Between Currency Crises and Macroeconomic Variables: A Theoretical Perspective

Abstract

Throughout history, the global economy has experienced repeated episodes of financial turmoil, including the Tulip Mania of 1636, the 1929 Great Depression, the 1992 European Currency Crisis, the Mexican Crisis 1994 the 1997 Asian currency turmoil, the 1998 financial crises in Russia and Latin America, Argentina’s severe economic downturn between 1998 and 2002, the 2008 global subprime mortgage crisis, and the economic disruption associated with the COVID 19 pandemic. A financial crisis generally occurs when credit and asset prices change abruptly, the normal operation of financial institutions is disrupted, balance sheets in many parts of the economy become fragile, and large-scale support from the government is required. In the academic literature, crises are typically grouped into four categories: exchange rate crises, sudden stop episodes or balance of payments crises, crises involving sovereign debt and banking crises. A currency crisis arises when a currency comes under intense speculative pressure that leads to a marked devaluation or depreciation. In defending the currency, authorities may run down foreign exchange reserves, sharply increase interest rates, or introduce capital controls, particularly under fixed exchange rate regimes. Around such episodes, macroeconomic indicators such as international reserves, trade balances, exchange rates, interest rates, domestic credit, and foreign debt ratios tend to show pronounced movements. Speculative attacks, whether successful or not, often impose high adjustment costs, either through large exchange rate depreciation or through severe reserve losses and elevated interest rates.