Interest rates, terms of trade and currency crises: Are we on the verge of a new crisis in the periphery?

In this paper we develop a simple model of currency crises, which emphasizes the role of currency mismatches and the balance of payments constraint. In our model, crises are driven by external shocks, particularly foreign interest rate and terms of trade shocks, which drive payments imbalances. In a reversal of conventional causality, we show how a currency crisis can then produce a domestic fiscal crisis. We then discuss the historical relevance of the model, tracing the major waves of currency and fiscal crises. The paper concludes with an assessment of the current situation of the peripheral countries in light of our model and argues that concerns of a renewed wave of currency crises may be overstated.

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