Exchange for Growth: Currency Dynamics in Emerging Markets

Abstract: Currency crises are frequently discussed retrospectively as a necessary and deterministic outcome of a finite sequence of fiscal decisions, monetary manoeuvres, and limited exogenous inputs. Parallelly, the Twin Deficits Hypothesis (TDH) posits that an increase in the budget deficit leads to a direct rise in the current account deficit; although analogous to the idea of currency crises being the outcome of finite inputs (through a balance of payments crisis here), this notion runs contrary to the conclusion that independent intervention can have bearing on the expression of a currency crisis. Since its introduction by Mundell and Fleming in 1960, the TDH has sparked considerable academic debate regarding its validity. Given its assumption of a stable private savings gap, and conflicting empirical evidence, we believe there are novel insights to be gained from a more nuanced approach incorporating theoretical frameworks from contemporary Monetary Economics in order to reconcile criticisms of the TDH with the basis for its broad applicability. The results from this paper thus investigate the link - or lack thereof - between real economic factors, which can support the assessment of fiscal policy autonomy, and thereby a government's ability, to meet domestic policy objectives without compromising trade policy autonomy and current account sustainability.