Macroeconomic Adjustment and Currency Crisis: A Third Generation Approach Under Rational Expectation

The objective of the paper is to focus on the transmission details of macroeconomic adjustment in a crisis-prone economy. The nature of currency crisis is examined in terms of the third generation approach as suggested by Krugman and Kim. According to this approach currency depreciation involves net contractionary effect on aggregate demand due to adverse effect on firms' balance sheet. Since crisis itself is a shock, involving adjustment in output and exchange rate, the model developed in the paper studies interaction between the real and the financial sector. In this model commodity prices are rigid, asset prices are flexible and expectation is rationally formed. The different comparative static propositions attempted in this paper suggest the role of monetary contraction and fiscal expansion in mitigating the contractionary effects of currency crisis. The paper also studies implications of adverse external shock. It is argued that external shock exacerbates the real sector contraction, which currency crisis always involves through the balance sheet effect on firms' investment. Broad policy messages of the paper are that sequencing of capital account liberalization has to be judiciously chosen and financial openness should follow under prudential supervision.