as a result of an attack by "speculators" despite intervention efforts by the central banks of Britain and Germany. Subsequent attacks on other European currencies in 1993 forced the realignment of the stabilization bands of the European exchange rate mechanism to 15 percent from 2.25 percent, a change that renders that type of band mechanism virtually inert (Smith, 1995).
A Theoretical Overview of a Currency Crisis
A government can peg the exchange value of its currency in a variety of ways. A country with highly developed financial markets, such as the U.S., can use open-market operations, intervention in the forward exchange market and direct operations in foreign assets to defend an exchange parity. (Krugman, 1979). But all such techniques appear subject to limits. A government attempting to keep its currency from depreciating may find its foreign reserves exhausted and its borrowing approaching a limit. A government attempting to prevent its currency from appreciating may find the cost in domestic inflation unacceptable. Finally when a government is no longer able to defend a fixed parity because of
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