Currency Crises and Monetary Policy in an Economy with Credit Constraint and Risk Premium

This paper extends the currency crises model of Aghion, Bacchetta and Baner-jee (2000, 2001, 2004) in two directions. First, we consider the medium term effects including the impact of monetary policy. We show that adverse medium term effects are present in some scenarios that can potentially reverse the monetary policy rec-ommendation in the original model. A tight monetary policy can have adverse effects beyond the short term and can potentially cause a currency crisis in the medium term. Second, we add a risk premium and find that this increases the likelihood of a crisis, can help explain contagion, and that prospective capital controls will increase the risk premium and therefore increase the likelihood that such controls will be needed as an emergency measure