Currency Crises: Strategic Game between Central Bank and Spot Speculators
Imperial College Management School Discussion Paper No. SWP9814/F
23 Pages Posted: 3 Jul 2009
Date Written: March 1, 2000
The paper studies an optimal switching policy between fixed and floating exchange rate regimes when the central bank dislikes losing reserves. We show that the optimal central bank intervention rule is not fully transparent in that the central bank will choose to randomize the devaluation over a range of the shadow exchange rate values to prevent a massive loss of reserves at one point in time. As a result, the collapse of the exchange rate becomes unpredictable even under perfect information and common knowledge. However, unlike in models with multiple equilibria we can determine the probability of the collapse within our model. The collapse probability is endogenously determined from the interaction between the central bank and the speculators as a unique function of the shadow exchange rate. The model is therefore able to predict how unpredictable the currency devaluation is.
Keywords: speculative attack, fixed exchange rate, optimal regime switch, reserves, spot speculation, constructive ambiguity
JEL Classification: F31, E58, G11
Suggested Citation: Suggested Citation