Evaluating Currency Crises: The Case of European Monetary System

In this paper we examine the nature of currency crises. We ascertain whether the currency crises of the European Monetary System (EMS) were based either on bad fundamentals, or on self-fulfilling market expectations driven by external uncertainty, or a combination of both. In particular, we extent previous work of Jeane and Masson (2000) regarding evaluation of currency crisis. To this end we contribute to the existing literature proposing the use of three different Markov regime-switching models. Our empirical results suggest that the currency crises of the EMS were not due only to market expectations driven by external uncertainty, or `sunspots', but also to fundamental variables that help explain the behaviour of market expectations.