This paper proposes a theory of twin banking-currency crises in which both fundamentals and self-fulfilling beliefs play crucial roles. Fundamentals determine whether crises will occur. Self-fulfilling beliefs determine when they occur. The fundamental that causes twin crises' is government guarantees to domestic banks' foreign creditors. When these guarantees are in place twin crises inevitably occur, but their timing is a multiple equilibrium phenomenon that depends on agents' beliefs. So while self-fulfilling beliefs have an important role to play, twin crises do not happen just anywhere. They happen in countries where there are fundamental problems - problems such as guarantees to the financial sector.
*Published:
Burnside, Craig, Martin Eichenbaum and Sergio Rebelo. "Government Guarantees And Self-Fulfilling Speculative Attacks," Journal of Economic Theory, 2004, v119(1,Nov), 31-63.
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