Strategic Complementarities and the Twin Crises

Abstract

The economic literature emphasised the role of strategic complementarities in generating banking crises and currency crises. Motivated by evidence from recent financial crises, we study a model, where strategic complementarities exist, not only within a group of creditors or within a group of currency speculators, but also between the two groups. The additional type of complementarities generates a vicious circle between banking crises and currency crises. This magnifies the correlation between the two crises and destabilises the economy. We show that, due to the vicious circle, a Lender of Last Resort might not be able to prevent bank runs.

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