This paper extends the currency crises model of Aghion, Bacchetta and Banerjee (2000, 2001, 2004) in different directions. Our main result is that a tight monetary policy can have adverse effects beyond the short term and can potentially cause a currency crisis in the medium term, even in cases when the interest rate defense is successful and prevented a currency crisis in the short-run. In addition, we add a risk premium and find that this increases the likelihood of a crisis, can help explain contagion, and that prospective capital controls will increase the likelihood that such controls will be needed as an emergency measure.
North American Journal of Economics and Finance, 2010, Vol 21, Issue 1, p. 5-18
Faculty of Social Sciences; foreign-currency debt; balance sheets; interest parity; risk premium; contagion; prospective capital control; monetary policy