The Asian Financial Crisis: The third crisis model

Abstract

The financial crises in developing countries, especially in Latin America, throughout the decades from the 1950s to the 1970s involved depressed financial systems, increased government deficits, and fixed exchange rates. In a depressed financial system, interest rates are controlled at lower than equilibrium levels so as to reduce the cost of lending. At the same time, the government runs a large fiscal deficit, which is usually financed by external debts, or alternatively, by an inflation tax, or by a high reserve requirement imposed on the commercial banks. The government deficit is high and the inflation rate increases but the exchange rate is fixed. Accordingly, the government has to draw down its foreign reserves to protect the exchange rate. A shock, such as a deteriorative change in the terms of trade that leads to an increase in the foreign trade deficit, leads to a speculative attack on the domestic currency and makes the foreign reserves dry up. The government is forced to abandon the fixed exchange rate regime and devalue the domestic currency. This is a typical description of a currency crisis.