Another Twin Crisis : Currency and Debt Crisis

Empirically, currency crises are more frequently accompanied by sovereign debt crises than by banking crises. Nevertheless the phenomenon of twin currency and debt crises has so far been neglected in economic literature. We analyze the optimal policy of a government that may choose and combine two policy alternatives. She may choose at the same time whether to keep or alternatively exit an existing exchange rate peg and whether or not to default on her debt. Both a devaluation and a default can be used to finance public expenditure. In addition both parameters have a large impact on the public welfare. The resulting incentive system can generate situations with self-fulfilling expectations. In some situations an internal contagion e.ect arises. A crisis in the sovereign debt market spreads to the sector of exchange rate policy and causes a devaluation as well. Private investors' default expectations thus can not only cause a sovereign debt crisis but may lead to a currency crisis as well