Working Paper: CEPR ID: DP2565
Authors: Craig Burnside; Martin Eichenbaum; Sergio Rebelo
Abstract: This paper proposes a theory of twin banking-currency crises in which both fundamentals and self-fulfilling beliefs play crucial roles. Fundamentals determine whether crises will occur. Self-fulfilling beliefs determine when they occur. The fundamental that causes ?twin crises? is government guarantees to domestic banks' foreign creditors. When these guarantees are in place twin crises inevitably occur, but their timing is a multiple equilibrium phenomenon that depends on agents' beliefs. So while self-fulfilling beliefs have an important role to play, twin crises do not happen just anywhere. They happen in countries where there are fundamental problems, such as guarantees to the financial sector.
Keywords: Fixed exchange rate regimes; Government guarantees; Hedging; Speculative attacks
JEL Codes: F31; F41; G15; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government guarantees (H81) | twin crises (H12) |
| self-fulfilling beliefs (D83) | twin crises (H12) |
| government's commitment to financial stability (G28) | twin crises (H12) |
| government's ability to manage reserves (H12) | twin crises (H12) |