Optimal currency crises

Abstract

Flawed government policies have been offered as an explanation for currency crises in most of the previous literature. With few exceptions, the role of the banking system is ignored. Empirical evidence suggests that in recent decades banking crises and currency crises have been linked. A model is developed here where the “twin” crises result from low asset returns. Large movements in exchange rates are desirable to the extent that they allow better risk-sharing between a country's bank depositors and the international bond market. The rationale for using short-term debt denominated in a foreign reserve currency is also investigated.