We build a model of financial sector illiquidity in an open economy. Illiquidity is defined as a situation in which a country's consolidated financial system has potential short-term obligations that exceed the amount of foreign currency available on short notice. We show that illiquidity is key in the generation of self-fulfilling bank and/or currency crises. We discuss the policy implications of the model and study issues associated with capital inflows and the maturity of external debt, the role of real exchange depreciation, options for financial regulation, fiscal policy, and exchange rate regimes.
JEL classification: F3, E5, G2
Key words: crises, financial systems, exchange rate systems, liquidity
This paper is forthcoming in the NBER Macroeconomics Annual 1999. The authors thank Philippe Aghion, Abhijit Banerjee, Ben Bernanke, Dean Corbae, Laura Hastings, Julio Rotemberg, Nouriel Roubini, Aaron Tornell, Chris Waller, and seminar participants at Harvard, Yale, the University of Kentucky, and the University of Pittsburgh for useful comments. Velasco acknowledges support from the C.V. Starr Center for Applied Economics at NYU. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
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