Arbitrage mechanism leading to currency crises: a theoretical perspective

In his seminal contribution on exchange rate crises, Krugman models speculative attacks as optimal market reactions to policy rules that are inconsistent with the inde…nite survival of a …xed nominal parity. Later contributions have shifted the focus of the analysis, modelling exchange rate crises as rational decisions by optimizing policy makers to abandon the peg. This paper analyzes the logical core of the two modelling strategies in terms of arbitrage. We use a generalized version of the â€arbitrage rule†…rst discussed by Flood and Garber, that expresses the conditions for a crisis to occur in the metric of the shadow exchange rate. Our arbitrage-based methodology of analysis can be applied to virtually all models of exchange rate crises.