Currency crisis , financial crisis , and large output loss ∗

Given the volatility of exchange rates, there is a reemergence of interest in the effect of such volatility, in particular of large currency shocks, on the domestic financial markets and the output and investment decisions of firms. We use a portfolio approach to model the occurrence of large exchange rate shocks as deriving from the asset allocation decisions of the households of a small open economy. Given contemporary small open economies like Thailand, where a large fraction of debt is denominated in foreign currencies, for example in dollars, exchange rate shocks have a strong impact on the liabilities of firms, households, banks and the government. Following a model sketched by Krugman (1999, 2001) we show rigorously in a simple dynamic Mundell-Fleming-Tobin model that such large currency shocks set in motion financial market and investment reactions that can, due to the existence of multiple equilibria, lead to low level equilibria and large output losses, despite significant improvements in the trade balance of the considered economy.