| Summary: | We develop a stylized real model of the Asian crisis where an adverse extenal shock can lead to real exchange rate overshooting. Domestic borrowers of foreign capital are bound by debt contracts even when the capital is unable to earn the world rate of return. Following an adverse shock, the requirement to honour these debt contracts leads to a debt overhang. In the long run, when capital becomes mobile, extra-marginal projects are shut down as capital departs, and the real exchange rate falls by more than the terms of trade shock. In the short run, the real exchange rate is partly determined by demand conditions by means of what we call the wage and overhang multipliers. For reasonable production and consumption parameters, the short run real exchange rate - driven by the wage and overhang multipliers - overshoots its long run value.
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