Currency crises in the European Exchange Rate Mechanism

Piard, Sylviane (1999) Currency crises in the European Exchange Rate Mechanism. Doctoral thesis, London Guildhall University.


The aim of the thesis is to examine the causes of currency crises. At the empirical level, the thesis sets out to examine the experience of two member countries of the ERM: Italy and France. It provides a new formal investigation of the underlying determinants of currency crises in these countries and therefore fills a gap in the applied literature on the ERM.

In contrast to existing work, the thesis uses two proxies of speculative pressure - an index of exchange market pressure and drift-adjusted realignment expectations. Another contribution of the thesis is the use a modelling methodology based on the Markov regime switching model with time-varying transition probabilities, which overcomes the main limitations of previously employed approaches. The distribution of each proxy of speculative pressure determines the two states of the foreign exchange market, defined as normal (i.e. credible) and crisis (i.e. speculative), whose discrete shifts are functions of economic variables.

For both currencies, the switching model satisfactorily captures the conventionally recognised episodes of speculative pressure and the influence of economic variables on currency crises. The conclusions support the view that "good" fundamentals will ensure currency stability and "bad" fundamentals will provoke the emergence of high speculative pressure (in particular in the case of Italy). A striking feature is that the estimation results vary according to the crisis proxy employed. Interestingly, it appears that the index of exchange market pressure performs better than the estimated realignment expectations.

On the theoretical side, political factors - albeit widely discussed - are generally not accounted for in existing currency crisis models. An important contribution of the thesis is the development of an optimising currency crisis model that allows the presence of partisan parties to affect the determination of its equilibria. It is showed analytically that the more likely it is that the party which is soft on unemployment will be elected, the more inevitable the crisis is. The empirical analysis suggests that crises are more likely when there is a general election in France, but no conclusive evidence is found that other political factors are a key feature in the determination of the French and Italian crises.

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