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The authors are assistant professor and professor (respectively) in the Department of Economics, University of Hagen, Hagen, Germany. This paper was presented at the thirteenth International Economic Association World Conference 2002 in Lisbon. The authors are grateful for helpful comments from seminar participants. They also would like to thank Robert Flood, Friedrich Kissmer, and two anonymous referees for valuable comments.
Masson, in fact, presents three explanations for the simultaneous occurrence of crises. The first explanation, which Masson calls monsoonal effects, is logically different from the other two (which we discuss below). Monsoonal effects refer to a shock that hits more than one country and therefore triggers more than one crisis. This explanation does not offer reasons why a crisis in one country might trigger a crisis in another; rather, it focuses on common environmental factors. The other two explanations, however, describe the impact that a crisis in one country can have on the stability of fixed exchange rates in other countries. In this paper we present only these two explanations for the spread of currency crises.
We abstract here from a real interest rate influence on aggregate demand. Buiter, Corsetti, and Pesenti (1998) use a more general model in which an interest channel for the transmission of monetary policy is considered to study the collapse of the Exchange Rate Mechanism of the European Monetary System.
Actually, profit maximization requires
More formally, wage setters minimize Et-1(nA,t)2 = Et−1(mA,t − wA,t)2. Thus, we employ a quite simple objective function for the trade union to keep the model tractable. A comprehensive analysis of the economics of the trade union can be found in Booth (1995).
The policymaker's objective function (9) is interpreted as a social loss function reflecting the social costs resulting from the social “bads” unemployment and inflation.
That is, the policymaker cares about all workers, not just unionized workers.
This approach is quite common in the policy coordination literature (see, for example, Ghosh and Masson, 1994).
Cavallari and Corsetti (2000) introduced the SDR into the second-generation currency crisis models.
We consider only the case of a devaluation of the previously fixed exchange rate. Revaluations are assumed to be impossible.
In our model, currency crises are clearly expansionary; in reality, many currency crises have a contractionary effect on output. Two remarks seem necessary here. First, empirical research shows that currency crises in emerging markets and in industrialized countries are fundamentally different (for example, Calvo and Reinhart, 2002). While crisis-induced devaluations in emerging markets may trigger a short-lived slowdown in growth or even a contraction in output resulting from a typically high foreign indebtedness (dollarized liabilities), this is not the case in industrialized countries (a well-known example for the expansionary effect of a currency crisis is the United Kingdom after abandoning the ERM). Second, we do not intend to explain a specific crisis episode. We are presenting a model for the theoretical study of the spread of a crisis along trade links.
An increase in the money supply expectation resulting from an increase in the crisis probability leads only to a fall in the shock's threshold value if α(l - α)θ/(δ + ∊) > 1 holds.
Masson (1999) derives an analogous equation; however, in his model, the crisis probability is defined as the probability that central bank reserves fall below some threshold value, as in the classic currency crisis models along the lines of Krugman (1979) and Flood and Garber (1984).
Equation (12) shows that an increase in wages (an increase in the expected money supply) produces an appreciation of the periphery countries' bilateral real exchange rate vis-à-vis that of the center country through an increase in their price levels.
We are grateful to an anonymous referee for suggesting this way of interpreting our results.