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to the political economy of the operations in exchange rate regimes. We draw on this literature to bring the key factors playing a role in biased operations of managed or adjustable peg regimes of exchange rate leaning towards unnecessary delay in making adjustments. This analysis provides a sort of checklist of reforms that are helpful to some countries to ensure that the exchange rate regime will not be a source of their political and economic instability.

 

There is a large amount of research offering details on causes and eventual effects by distinguishing among various types of currency crisis. The original type is called “first-generation” crisis that occurs due to deteriorating macroeconomic fundamentals, chiefly large current account deficits, overvaluation of currency, high budget deficits paired with high money supply growth and domestic credit. In this case speculative attacks are inevitable and the end result is a depreciation of the exchange rate (Krugman, 1979). As a result of these dreadful macroeconomic fundamentals, the scope of responding for the policymakers is largely limited.

 

The other type of currency crisis occurs even when the macroeconomic fundamentals are in good shape. This is called “second-generation” crisis and it happens due to government reaction (Obstfeld, 1994). In the event of this type of crisis, the self-fulfilling speculative attacks prediction might take place and be successful since it will cause the materialization of speculative pressure. Such beliefs can emerge as a consequence of emerging recession in a country and the crucial policy adjustment will be assessed too painful, thus the modification does not happen. In these situation the scope for action is larger, however, the responses are very significantly.

 

Based on the literature, how governments respond to crises depends solely on the nature and type of crisis. If the basic macroeconomic conditions are poor, the exchange rate or other macroeconomic policies need for sure to be adjusted; however, if they are of mediocre quality, adjustments are not necessarily vital. We can also observer a very interesting fact – that is, policymakers most of the times tend to protect and support the exchange rate in any of the above mentioned situations. Their behavior is particularly ambiguous given that when conditions are so poor, independent observers see exchange rate adjustment as an inevitable process. Nevertheless, in most of the cases we can see that policymakers tried to defend the exchange rate regime.

 

Currency devaluation, in most of the cases, comes after a country realizes that its currency is overvalued relative to other major world currencies. It is a powerful tool to improve the terms of trade or stimulate export industries. Policies like this, assume that devaluations make the country’s exports more attractive to foreigners, and imports by foreigners to the country less attractive. In reality, however, there are other factors that need to be considered before undertaking such a risky planned devaluation .

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