Loss of confidence and currency crises

Spanjers, Willy (2005) Loss of confidence and currency crises. (Discussion Paper) Kingston upon Thames, U.K. : Faculty of Arts and Social Sciences, Kingston University. 32 p. (Economics Discussion Paper)


Loss of confidence is interpreted as an increase in the ambiguity experienced by investors who maximize Choquet Expected Utility. Currency crises are modelled to resemble bankruns. Using countries having fragile financial systems, a model of twin crises is obtained. An exogenous interim loss of confidence may trigger a crisis, even when the 'fundamentals' remain unchanged. Not recognizing ambiguity has a similar effect. Investors 'overreact' to bad news, as it leads to an endogenous loss of confidence. The stylized facts of the South-East Asian crisis fit the model, and it conforms well to the basic structure of the EU-accession countries in the run-up to their adoption of the Euro. Transparency, competence, and political stability, offer some protection against currency crises by increasing the level of confidence. The best protection, however, is provided by a stable financial system, as this enables share prices to absorb the impact of a loss of confidence.

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