Author: Paul Krugman
Publication: Journal of Money, Credit, and Banking. vol. 11, no. 3. pp. 311-325
Date: August 1979
Excerpt:
A government can peg the exchange value of its currency in a variety of ways. In a country with highly-developed financial markets it can use open-market operations, intervention in the forward exchange market, and direct operations in foreign assets to defend exchange parity (see [2] for an analysis of central bank operations and their effects on the exchange rate); the list could be extended to include other such instruments as changes in bank reserve requirements. But all of these policy instruments are subject to limits. A government attempting to keep its currency from depreciating may find its foreign reserves exhausted and its borrowing approaching a limit. A government attempting to prevent its currency from appreciating may find the cost in domestic inflation unacceptable. When the government is no longer able to defend a fixed parity because of the constraints of its actions, there is a “crisis” in the balance of payments.
This paper is concerned with the analyses such crises. Although balance-of-payment crises have not received much theoretical attention, there are obviously features common to many crises, and the empirical regularities suggest that a common process must be at work. A “standard” crisis occurs in something like the following manner. A country will have a pegged exchange rate; for simplicity, assume that pegging is done solely through direct intervention in the foreign exchange market. At the exchange rate, the government’s reserves gradually decline. then at some point, generally well before the gradual depletion of reserves would have exhausted them, there is a sudden speculative attack that rapidly eliminates the last of the reserves. The government then becomes unable to defend the exchange rate any longer.
Link: A Model of Balance-of-Payments Crises (PDF)