A model of the interactions between asset prices bubble bursts and twin crises

Abstract

This study develops a model to analyze the Interactions between twin crises—the banking crisis and the currency crisis—and their coincidence with the asset prices bubble bursts. Results show that the origin of both crises comes from agents worrying about the upcoming asset prices bubble bursts when bad economic fundamentals are announced. There are multiple equilibria crises in both two systems. Twin crises are caused by deteriorated fundamentals and fundamental-driven self-fulfilling prophecy. Our model offers some policy implications. First, it is unable to prevent twin crises by suspending deposit convertibility, full deposit insurance and financial dollarization. Second, suspension of currency convertibility can prevent a currency crisis, but not a banking crisis. However, the effect of lender of last resort is ambiguous. Finally, strict risk supervision and minimum capital requirements each can curtail twin crises.