Political-Economy Crisis Models

Abstract

By eliminating distractive noise, good economic models help us understand relationships of cause and effect in the analysis of empirical phenomena. At the same time, they should not abstract from reality to such an extent as to render their theoretical predictions trivial, and therefore more or less irrelevant for the explanation of observable outcomes. This challenge can sometimes be daunting. In particular, through largely neglecting the political dimension of currency crises, the main strands of the theoretical literature risk losing a potentially important channel for explaining the collapse of currency pegs when times get tough. This omission appears misplaced, given that professional currency investors tend to devote significant resources to analyzing the impact of political conditions on exchange rate stability;56 it also leaves too much room for attributing currency crises to exogenous factors beyond the scope of the models, such as arbitrary shifts in expectations.