External Shocks, Balance Sheet Contagion, and Speculative Attack on the Pegged Exchange Rate System

Abstract

A simple monetary model is built to illustrate that the pegged exchange rate system will collapse under an unstable external environment via the balance sheet contagion and the “boiling frog” effect, even if the domestic policy and the fundamentals are sound. If agents anticipate this happening, a speculative attack may still occur. This result is different from that of the first-generation currency crisis model, where the inconsistent domestic policy brings in the collapse of the peg. The policy options to defend the peg in the author's model depend on the nature of the shock. Effective capital control can only be implemented for capital outflow shock. Capital account deregulation is more stabilizing under a current account deficit shock, however. This paper also distinguishes the effect of capital mobility with that of the asset substitutability, as they have completely different impacts on the peg.