Surprise from the Central Bank: A Model to Understand Currency Revaluation Decisions

37 Pages Posted: 24 Sep 2016

See all articles by Yilun Zhu

Yilun Zhu

Yale University, Department of Economics, Students

Date Written: June 13, 2016

Abstract

Are countries chronically resisting revaluations vulnerable to speculative attacks? I study the timing of a Central Bank's decision to optimally abandon a currency peg in order to avoid accumulating excessive foreign currency reserves on its balance sheet. The central assumption is that foreign reserves are risky and an excessive amount of them hurts a Central Bank. But abandoning the peg causes the currency to appreciate, which in turn results in a negative output shock that increases with the size of the appreciation. I show that after taking both costs into account, a Central Bank would avoid predictable speculative attacks by introducing uncertainty to the market and announcing its unpegging decision as a surprise. This randomized strategy would lead to a prolonged period of increased speculation against the peg. This model shows that Swiss National Bank's surprise move to unpeg its currency in January of 2015 is consistent with a rational and optimizing Central Bank.

Keywords: Speculative Attack, Revaluation, Forward-Looking Central Bank

JEL Classification: F31, E58

Suggested Citation

Zhu, Yilun, Surprise from the Central Bank: A Model to Understand Currency Revaluation Decisions (June 13, 2016). Available at SSRN: https://ssrn.com/abstract=2795195 or http://dx.doi.org/10.2139/ssrn.2795195

Yilun Zhu (Contact Author)

Yale University, Department of Economics, Students ( email )

28 Hillhouse Ave
New Haven, CT 06520-8268
United States

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