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This paper presents a general equilibrium currency crisis model of the ‘third generation’, in which the possibility of currency crises is driven by the interplay between private firms’ credit-constraints and nominal price rigidities. Despite our emphasis on microfoundations, the model remains sufficiently simple that the policy analysis can be conducted graphically. The analysis hinges on four main features (i) ex post deviations from purchasing power parity; (ii) credit constraints a la Bernanke–Gertler; (iii) foreign currency borrowing by domestic firms; (iv) a competitive banking sector lending to firms and holding reserves and a monetary policy conducted either through open market operations or short-term lending facilities. We derive sufficient conditions for the existence of a sunspot equilibrium with currency crises. We show that an interest rate increase intended to support the currency in a crisis may not be effective, but that a relaxation of short-term lending facilities can make this policy effective by attenuating the rise in interest rates relevant to firms.

Researchers in recent years have had to grapple with the puzzle of how fastgrowing economies with large export surpluses and substantial government surpluses, could end up in the space of months, in a deep and damaging currency crisis. This paper builds on a very simple story of why things fall apart quite so dramatically if domestic prices do not adjust fully to exchange rate changes in the short run, a currency depreciation leads to an increase in the debt burden of domestic firms that borrowed in foreign currency, and consequently a fall in profits.1 Since lower profits reduce net worth, this may result in reduced investment by creditconstrained firms, and therefore in a lower level of economic activity in the following period. This, in turn, will bring a fall in the demand for money, and thus a currency depreciation in that next period. But arbitrage in the foreign exchange market then impliesthat the currency must depreciate in the current period as well. Hence the possibility of multiple short run equilibria in the market for foreign exchange. A currency crisis occurs when an expectational shock pushes the economy into the ‘‘bad’’ equilibrium with low output and a high nominal exchange rate. This story is compelling for a number of reasons. First, there is evidence that foreign currency exposure is correlated with the likelihood of a crisis in particular, Hausmann et al. [24] show that the countries most likely to go into a crisis were those in which firmshe ld a lot of foreign currency denominated debt.2 Second, there is strong evidence that exchange rate changes are incorporated into domestic prices relatively slowly. For example, Goldfajn andWerlang [22] compute the pass-through from exchange rate to pricesin a set of 71 countriesincludi ng both developed and less developed countries. They show that the pass-through is very gradual and tends to be even smaller after currency crises—in the Asian crises, for example, less than 20% of currency depreciation wasreflected in inflation after 12 months. Third, it is widely accepted that an important link between the currency crises and the subsequent fall in output was a financial crisis which affected the ability of private firmsto finance production—indeed thisiswhy the crisesare often described astrip le (currency, financial, output...) crises.3 Fourth, the model predictsthat such crisesare most likely to occur in economies at an intermediate level of financial development (i.e., not in the US and not in Burma) and cannot be ruled out by what are conventionally viewed as prudent government policies, which in turn seems consistent with the facts. This is not the first paper to tell a story of this kind. Our earlier papers on the subject [4,5] feature the same basic story, as does the related paper by Krugman [30]. In this paper we delve deeper into the story by integrating the monetary side of the economy together with itscred it side, through the natural channel of modeling the needs of the banking sector for reserves. This is important because a key question in these papers has been the role of monetary policy in a crisis, and this obviously depends crucially on how monetary policy affects firms’ access to credit.4 Moreover, explicitly modeling the relation between the central bank and the banking sector, naturally leads us to consider a richer menu of monetary policy instruments than is standard in the literature. We are thus able to ask questions about the optimal mix of monetary policy instruments in a crisis. Interestingly, it turns out that it may be optimal to tighten money supply through open market operations but at the same time to ease the supply of emergency credit to banks through the so-called discount window. There are a number of other recent papers which have studied the issue of monetary policy in related contexts. Apart from our own previous papers already mentioned above, the most closely related literature includes Gertler et al. [21] Ce´spedes et al. [15] and Christiano et al. [18]. All of these papers share the conclusion that even in a crisis it may be a good idea to let the exchange rate go down further. Gertler et al. and Cespedes et al. interpret this result as supporting the case for flexible exchange rates over fixed exchange rates, while Christiano et al. see it as a case for relaxing monetary controls in a crisis even at the cost of an exchange rate depreciation. The one important difference between these papers and ours is that they operate in an environment where there isa unique equilibrium. In Aghion et al. [5] we had shown that there are circumstances where the equilibrium is always unique and in such cases, the case for taking a relaxed monetary stance and letting the exchange rate float down is much stronger, consistent with the message of these papers. In contrast, our analysis in this paper focuses exclusively on the multiple equilibrium case.The paper isorganiz ed asfollows . Section 2 laysout the general framework, including the borrowing and investment decisions of domestic manufacturing firms, and endogenizing their credit constraints. Section 3 describes the monetary side of the economy; in particular, it derivesthe demand for reservesby banksin relation to the supply of credit to domestic manufacturing firms, thereby generating a reserves market equilibrium equation. Together with interest parity, this equation determines a relationship from future expected output to current nominal exchange rate which we refer to asthe ‘‘IPLM’’ (or ‘‘interest-parity-LM’’) curve. Section 4 concentrates on the real side of the economy, which leads to expressing future output as a function of the current nominal exchange rate; we refer to this second relationship between those two variables, as the ‘‘W’’ (or ‘‘wealth’’) curve. Section 5 analyzes the sunspot equilibria of thismodel; in particular it providess ufficient conditionsfor the existence of non-deterministic sunspot equilibria, and thus for the occurrence of expectational shocks and the possibility of currency crises. Section 6 uses a simple graphical representation of the model to discuss the stabilization effects of open market operations and of discount window-types of policies. Finally, Section 7 concludes by suggesting potential extensions.

This pap er has concentra ted on developing a full-fledged ‘‘third generation’’ model of currency crises. Whilst we have focused our attention on micro foundations, we have left out a number of interesting implications and extensions of this type of model. A first extension is to analyze the post-crisis dynamics of output. In the simple benchmark case considered in the above graphical analysis, there is a progressive recovery after a crisis, as firms build up their net worth. While the recovery is influenced by the policy at the time of the crisis, it is also influenced by monetary policy in the aftermath of the crisis. Thus, it would be of interest to examine the dynamics of output under various policy rules, such as inflation, monetary or exchange rate targeting. Longer lags of price stickiness and issues of credibility could also be introduced in the analysis. The precise mechanics of exchange rate policy have also been left out from the analysis, but in Aghion et al. [5] we show that assuming a fixed exchange rate does not affect the analysis in any substantial way. If the nominal exchange rate is fixed, the central bank has to change its money supply, e.g., through interventionsin the foreign exchange market. If we assume that there is a lower limit to money supply, e.g., through a lower limit on international reserves as in Krugman [28], the central bank will not be able to defend the currency when large shocks occur. Alternatively, the nominal exchange rate described in this paper can then be reinterpreted as the ‘shadow’ exchange rate typically used in the currency crisis literature. If the shadow exchange rate isdeprecia ted enough, the fixed exchange rate hasto be abandoned and a large depreciation occurs. In that case, the analysis derived from the IPLM-W graph in the above policy section, carries through at the ‘good’ equilibrium the fixed exchange rate is sustained, while at the ‘crisis’ equilibrium the fixed rate is abandoned. While the mechanism leading to a crisis is similar under a floating or fixed exchange rate, there may be differences between the two regimes that are not considered in the model. For example, a fixed exchange rate could lead to a stronger real appreciation which makesmore likely that a large depreciation with default can happen. This result stresses the central role played by corporate balance sheets and the potentially minor role played by exchange rate policies. Obviously, a deterioration of public finance can also contribute to a financial crisis (as argued in first and second generation modelsof currency crises), in particular through potential crowding-out effects on the balance sheet of private firms. The role of public finance and public debt and its interaction with the private sector are examined in some detail in Aghion et al. [5]. In particular, a public debt in foreign currency can increase the likelihood of a currency crisis as the public sector’s loss from a devaluation may increase the interest payment and/or tax burden of firms. A critical simplification has been to assume a constant credit multiplier m: This assumption simplifies the analysis and allows a better exposition of the main mechanisms at work. However, in a more general framework, the credit multiplier is influenced by other variables such as the real interest rate (see Aghion et al. [5,6] for a model where m; depends negatively on the real interest rate). In this case, output may be more sensitive to monetary policy and the W curve is more likely to shift downward with a restrictive monetary policy. Thus, a currency crisis may be more difficult to avoid. Moreover, we should also try to understand better how the credit multiplier evolvesduring crises. The paper has focused on the foreign currency exposure of firms, but the exposure of banks is also an important characteristic of recent financial crises. In the current setting, banks fully lend in foreign currency, but have enough assets not to go bankrupt after a depreciation. An interesting extension of the analysis is to incorporate explicitly currency exposure at the banking level. If currency depreciations entail significant losses for banks, the lending process may be disrupted (the credit-multiplier m may be reduced) so that firms will again suffer from a currency depreciation. Introducing the possibility of a currency mismatch at both the bank and the firm levels, can provide new interesting insights. Finally, we have focused attention on currency crises induced by expectational shocks, that is on the existence of non-degenerate sunspot equilibria. A natural extension is to introduce exogenous shocks, for example on firms’ productivity. In particular, a (small) negative shock on productivity may have substantial effects on output and the nominal exchange rate if firmsare highly indebted in foreign currency, to the extent that such a shock may result in the IPLM and W curves intersecting more than once.