Abstract

http://ssrn.com/abstract=411542
 


 



When Is it Optimal to Abandon a Fixed Exchange Rate?


Sergio T. Rebelo


Northwestern University - Kellogg School of Management; Centre for Economic Policy Research (CEPR); University of Rochester - Department of Economics; National Bureau of Economic Research (NBER)

Carlos A. Vegh


University of Maryland - Department of Economics; University of California at Los Angeles; National Bureau of Economic Research (NBER)

April 2002



Abstract:     
This paper analyzes the optimal time to abandon a fixed exchange rate regime in response to a fiscal shock that renders the peg unsustainable. We consider three variants of an optimization-based first-generation speculative attack model. In the first variant there are exogenous costs of abandoning the fixed exchange rate. These costs may represent a bailout of the banking sector or output loss. The second variant endogenizes the costs of abandoning the fixed exchange rate in an economy with liability dollarization. The third variant incorporates a fiscal reform - which makes the peg sustainable once again - that arrives according to a Poisson process while the exchange rate is fixed. In all three cases, for a sufficiently large fiscal shock it is optimal to abandon the peg as soon as the shock occurs, regardless of the level of international reserves. This represents a sharp departure from the Krugman-Flood-Garber model. In that model the size of the underlying fiscal shock plays no direct role in the decision to abandon the peg and matters only insofar as it affects the speed at which reserves are depleted.

Number of Pages in PDF File: 48

Keywords: Currency crisis, speculative attacks, optimal policy, fixed exchange rates

JEL Classification: F31

working papers series





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Date posted: July 14, 2003  

Suggested Citation

Rebelo, Sergio T. and Vegh, Carlos A., When Is it Optimal to Abandon a Fixed Exchange Rate? (April 2002). Available at SSRN: http://ssrn.com/abstract=411542 or http://dx.doi.org/10.2139/ssrn.411542

Contact Information

Sergio Tavares Rebelo (Contact Author)
Northwestern University - Kellogg School of Management ( email )
2001 Sheridan Road
Leverone Hall
Evanston, IL 60208
United States
847-467-2329 (Phone)
847-491-5719 (Fax)
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
University of Rochester - Department of Economics ( email )
Harkness Hall
Rochester, NY 14627
United States
585-275-5252 (Phone)
585-256-2309 (Fax)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Carlos A. Vegh
University of Maryland - Department of Economics ( email )
College Park, MD 20742
United States
University of California at Los Angeles ( email )
Box 951477
Los Angeles, CA 90095-1477
United States
310-825-7371 (Phone)
310-825-9528 (Fax)
HOME PAGE: http://vegh.sscnet.ucla.edu
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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