Working Paper

On the fiscal implications of twin crises

Abstract: This paper explores the implications of different strategies for financing the fiscal cost of twin crises for inflation and depreciation rates. We use a first-generation type model of speculative attacks which has four key features: (i) the crisis is triggered by prospective deficits, (ii) there exists outstanding non-indexed government debt issued prior to the crises; (iii) a portion of the government's liabilities are not indexed to inflation; and (iv) there are nontradable goods and costs of distributing tradable goods, so that purchasing power parity does not hold. We show that the model can account for the high rates of devaluation and moderate rates of inflation often observed in the wake of currency crises. We use our model and the data to interpret the recent currency crises in Mexico and Korea. Our analysis suggest that the Mexican government is likely to pay for the bulk of the fiscal costs of its crisis through seignorage revenues. In contrast, the Korean government is likely to rely more on a combination of implicit and explicit fiscal reforms .

Keywords: Bank failures; Speculation; Inflation (Finance);

Bibliographic Information

Provider: Federal Reserve Bank of Chicago

Part of Series: Working Paper Series

Publication Date: 2001

Number: WP-01-02