Domino Effects in a Multilateral Peg Model of Currency Crisis with State-Contingent Reserve Dynamics

This work analyses the domino effects of the Exchange Rate Mechanism (ERM) crisis stemming from linkages in competitiveness already outlined in Gerlach and Smets (1995); an additional assumption that tries to explain the acceleration of the crises is the full sterilization of capital outflows within the ERM band which takes the form of state contingent reserve dynamics where depletion of reserves occurs as the nominal exchange rate deviates from the central parity. The drawback of such intervention is in the domestic credit growth which is supposed to be higher in one of the two countries. As the fundamentals get weaker people react by lowering the domestic currency holdings and by increasing the demand for bonds which leads to a reduction in the domestic interest rate. Such interest rate differential determines capital outflows that, if fully sterilized, causes a depletion of reserves and amplifies the size of the speculative attack; in fact full sterilization leaves the exchange rate, and therefore the existing interest rate differential, fixed, which in turn triggers greater outflows, with the result that the crisis is accelerated. Patterns of international trade (Glick and Rose 1998) are important in understanding how currency crises develop; such interrelations explain why the speculative pressure on the exchange rate parity increased in countries which were closely integrated with a country whose exchange rate parity was successfully attacked. The results presented in the paper also confirm that domino effects are amplified by rigidities in the labour markets, which amplify the pressure on domestic money balances coming from imported inflation.