This paper studies how the exposure of a country's corporate sector to interest rate and exchange rate changes affects the probability of a currency crisis. To analyze this question, we present a model that defines currency crises as situations in which the costs of maintaining a fixed exchange rate exceed the costs of abandonment. The results show that a higher exposure to interest rate changes increases the probability of crisis through an increased need for output loss compensation and an increased efficacy of monetary policy in stimulating output. A higher exposure to exchange rate changes also increases the need for output loss compensation. However, it lowers the efficacy of monetary policy in stimulating output through the adverse balance sheet effects of exchange rate depreciation. As a result, its effect on the probability of crisis is ambiguous.

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German Economic Review
Erasmus Research Institute of Management

Eijffinger, S., & Goderis, B. (2007). Currency crises, monetary policy and corporate balance sheets. German Economic Review, 8(3), 309–343. doi:10.1111/j.1468-0475.2007.00410.x