Strategic Complementarities and the Twin Crises*

The economic literature emphasised the role of strategic complementarities in generating banking crises and currency crises. Motivated by evidence from recent financial crises, we study a model, where strategic complementarities exist, not only within a group of creditors or within a group of currency speculators, but also between the two groups. The additional type of complementarities generates a vicious circle between banking crises and currency crises. This magnifies the correlation between the two crises and destabilises the economy. We show that, due to the vicious circle, a Lender of Last Resort might not be able to prevent bank runs.