Keywords

Twin crisis • Balance sheets • Net worth • Real exchange rate • Fundamentals • Asymmetric information • Firms and banks • External finance premium • Moral hazard • Self-fulfilling expectations • Disruptions • Savings and investment • Third-generation models • Perverse savings • Vicious circle

Introduction and terminology

After the work in Chapter 8 on exchange rates, Chapter 9 on currency crises and the role of international capital mobility, this chapter focuses more generally on financial crises of which currency crises are often an example. As with Chapter 9, and in contrast thus with Chapter 10, Chapter 11 zooms in on the drawbacks or costs of international capital mobility.

As we explained in Chapter 9, a currency crisis is a disruption on the currency market in which a speculative attack on a currency leads to a devaluation and/or to the monetary authorities defending the exchange rate by depleting their foreign exchange reserves and/or raising interest rates. A capital account crisis is the mirror image of a currency crisis, focusing on the sudden reversal of capital flows that accompanies the currency market disruption. As such, a currency or capital account crisis is a potential external channel for a financial crisis. Its domestic equivalent is a banking crisis, in which the increased fragility of a country’s banking sector, potentially leading to bank runs, forces the government to intervene and/or banks to scale down their business, which is a potential internal channel for a financial crisis. It is customary to refer to a ‘twin crisis’ if a banking crisis and a currency crisis occur (almost) at the same time. The word ‘potential’ is used in both cases above because not every currency crisis or banking crisis is a financial crisis.