Currency crises and the interest rate defence

While virtually all modern models of exchange rate crises recognise that the decision to abandon an exchange rate peg depends on how harshly policy makers are willing to defend the regime, they virtually never model how the exchange rate is defended. We argue that incorporating both the mechanics of speculation and a defence policy against speculation in the well-known currency crisis model of Morris and Shin (American Economic Review 88 (1998) 587-97) considerably improves its performance at explaining stylised features of speculative attacks. We develop a connection with the literature on exchange market pressure to confirm the predictions of our augmented model empirically.