Exchange Rate Crises and Fiscal Solvency


  • The author would like to thank two anonymous referees and the editor, Ken West, for very helpful suggestions on the original submission. Additionally, thanks are due to Dale Henderson, Olivier Jeanne, John Jones, Robert Martin, Christos Shiamptanis, and seminar participants at the Board of Governors of the Federal Reserve, the International Monetary Fund, the Central Bank of Cyprus, George Washington University, Williams College, the Econometric Society Winter Meetings, and the Mid-West Macro Meetings for helpful comments and discussions on earlier versions of this paper. Thanks also go to the Board of Governors of the Federal Reserve where the author worked on revisions while serving in a visiting position. The views in this paper are solely the responsibility of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve or of any other person associated with the Federal Reserve System.


This paper combines insights from generation one currency crisis models and the fiscal theory of the price level (FTPL) to create a dynamic FTPL model of currency crises. The initial fixed-exchange-rate policy entails risks due to an upper bound on government debt and stochastic surplus shocks. Agents refuse to lend into a position for which the value of debt exceeds the present value of expected future surpluses. Policy switching, usually combined with currency depreciation, restores fiscal solvency and lending. This model can explain a wide variety of crises, including those involving sovereign default. We illustrate by explaining the crisis in Argentina (2001).