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We address three questions: (i) Can classical models be reconciled with the fact that many crises are marked by high rates of depreciation and small increases in seignorage revenue? (ii) What are the implications of different financing methods for post-crisis rates of inflation and depreciation? (iii) How do governments pay for the fiscal costs associated with currency crises? To study these questions we use a general equilibrium model in which prospective government deficits trigger a currency crisis. We then use our model in conjunction with fiscal data to interpret government financing in the wake of three recent currency crises: Korea (1997), Mexico (1994) and Turkey (2001).

A classical view of currency crises is that they arise because governments print money to finance ongoing or prospective deficits. This view is embodied in so-called first-generation models and their modern variants.1 Despite their usefulness, these models suffer from a key shortcoming: they generally predict that seignorage should rise significantly in the aftermath of a currency crisis. Our examination of 6 recent currency crises indicates that this prediction is generally inconsistent with the data (see Table 1). Even though rates of depreciation in all the episodes we consider are very large (see Table 2), the increase in seignorage revenues is, at best, modest.This evidence raises three questions: • How do governments actually pay for the fiscal costs associated with currency crises? • What are the implications of different financing methods for post-crisis rates of inflation and depreciation? • Can we reconcile classical models with the fact that many crises are marked by high rates of depreciation and small increases in seignorage revenue? We address these questions using a general equilibrium model in which a currency crisis is triggered by prospective government deficits. We then use our model, in conjunction with fiscal data, to interpret government financing in the wake of three recent currency crises: Korea (1997), Mexico (1994), and Turkey (2001). Standard currency crisis models assume, for convenience, that the only source of depre- ciation-related revenue available to a government is seignorage. Our case studies show that in reality, governments have access to other types of depreciation-related revenue. First, they can deflate the dollar value of outstanding nonindexed debt. Second, they can engage in what we call an “implicit fiscal reform.” Such reforms happen when some government expenditures are denominated in units of local currency. As long as the government does not raise these expenditures at the rate of depreciation, their dollar value declines. This implicit fiscal reform can be quantitatively important even if government expenditures rise at the same rate as domestic inflation because post-crisis inflation rates are often much lower than the rate of depreciation (see Table 2). Our case studies indicate that for the three countries that we consider, seignorage was not the dominant source of additional government revenue in the aftermath of the crisis. In all cases, debt deflation was more important than seignorage and there were large declines in the dollar value of transfers. Indeed, in Korea and Mexico, these declines were the single most important source of government revenue after the crisis. Motivated by these findings, our model incorporates a version of the government's budget constraint that is more realistic than the highly stylized representations typically used in the literature. We consider a small open economy populated by a representative, infinitely lived agent who can borrow and lend at a fixed interest rate in world capital markets. Agents in the economy consume tradable and nontradable goods and receive endowments of both goods. In addition to allowing for nonindexed public debt and government spending, we assume that some government spending is on nontradable goods. This type of spending is important because, in reality, the dollar price of nontradable goods falls dramatically in the aftermath of a currency crisis (see Table 3). This fall has two effects on the government's intertemporal budget constraint. First, it lowers the dollar value of taxes collected from the nontradable sector. This effect underlies the conventional wisdom that a devaluation leads to a deterioration of the government's fiscal position. Second, the fall in the dollar price of nontradable goods reduces the dollar value of government expenditures on such goods. This second effect, which has not been stressed in the literature, leads to an improvement of the government's fiscal position. Since most governments’ expenditures are on nontradable goods (e.g., health and education), the latter effect may, in practice, be very important.Consistent with the data, we also assume that nontradable prices are sticky for a brief period of time. In addition, we suppose that distributing tradable goods requires the use of nontradable distribution services (retailing, wholesaling, and transportation). Given these assumptions, the model implies that the rate of depreciation in the first year after the crisis is larger than the rate of inflation. The presence of this wedge magnifies the post-crisis reduction in the dollar value of transfers and government purchases. This decline goes a long way toward offsetting the fall in the dollar value of taxes. We show that a version of our model calibrated to Korean data is consistent with the post-crisis behavior of seignorage, inflation, and depreciation rates in Korea. Based on this analysis, we conclude that classical models can be reconciled with observed seignorage, inflation, and depreciation rates in the aftermath of currency crises. Finally, we use the model to address the question, how large would post-crisis Korean inflation have been if the government had relied solely on seignorage revenue to finance the costs of the crisis? Our model implies that inflation would have been dramatically higher. In the first year of the crisis inflation would have been more than twice as high, and long-run inflation would have risen by a factor of ten. To focus attention on the impact of alternative government financing strategies, our model has a very stark information structure. Indeed, in our model the timing of the currency crisis is perfectly predictable. Clearly, this assumption is an oversimplification. Various authors (see Chari and Kehoe, 2003, and the references therein) have emphasized the role of informational frictions in introducing a stochastic element to the timing of currency crises. Although we are sympathetic to the importance of these frictions, the issues of government finance that we emphasize in this paper are equally relevant for models with a more realistic information structure. These issues are also relevant for stochastic first-generation models (e.g., Flood and Garber, 1984) and in second-generation models in which currency crises emerge as multiple equilibrium phenomena (see Jeanne, 1999, for a survey). The paper is organized as follows. Section 2 discusses the government budget constraint. Section 3 embeds this budget constraint into a general equilibrium model of a currency crisis. Section 4 presents the properties of the model. In Section 5 we summarize the results of our case studies. Section 6 contains our concluding remarks.

In this paper we explore the implications of different strategies for financing the fiscal costs associated with a currency crisis for inflation and depreciation rates. We argue that models based on the assumption that seignorage is the only depreciation-related source of revenue lead to misleading predictions about post-crisis rates of inflation and depreciation. We then show that models that incorporate an empirically plausible menu of depreciation-related revenues can account for the high depreciation rates and low inflation rates that are often observed in the aftermath of currency crises. Our case studies indicate that different governments pursue different financing strategies. For example, debt deflation played a more important role in Turkey than in Korea or Mexico. In contrast, the reduction in the dollar value of transfers played a very large role in Mexico. We are silent on why these governments chose different strategies. In our view, understanding the political economy considerations that underlie these choices is an important topic for future research.