Second generation models of currency crises: an application to Trinidad and Tobago

This paper analyses the government's choice of exchange rate regime from a political economy perspective. Building on the theoretical insights of second-generation exchange rate crisis models, the paper presents a modified model in which the choice to devalue or maintain a currency anchor in the face of shocks to the real economy in explicitly modeled within a maximising framework. The paper attempts to fit such a model to the experience of the Trinidad and Tobago economy over the twenty-five years. Trinidad and Tobago presents a useful example because it has devalued on a number of occasions and in response to various real stocks. Having estimated the coefficients of the model, the estimated ex ante probability of devaluation is ascertained for each period. Generally speaking , the model performs well. Parameter estimates all have the 'correct' sign, although not all are statistically significant. On two of the three devaluation occasions, the estimated probability reaches a maximum at the point if devaluation. Hence political economy factors appear to have played a significant role in the determination of exchange rate policy in Trinidad and Tobago.