ABSTRACT
In an open economy, foreign currencies and capital flows enter the picture. Portfolio capital in particular is highly mobile internationally. Consequently, the optimal portfolio with foreign currencies can be a very delicate equilibrium. For open economies with different currencies and with mobile portfolio capital, the nature and the mechanisms of financial crises change. The chapter shows that the financial crisis is a currency crisis. Speculative bubbles in exchange rates can be modeled as the actual exchange rate moving away from a fundamental rate. The chapter discusses a divergence between the nominal and the real exchange rate, occurring simultaneously with a widening current account deficit, can be a signal that the onset of a currency crisis is nearing. The Turkish currency crisis of 2001, after a crisis in 1993, exhibits some of the typical crisis pattern. Pegging the national currency to the US dollar contributed to an appreciation of the real exchange rate.
