When is it Optimal to Abandon a Fixed Exchange Rate?
48 Pages Posted: 14 Jul 2003
Date Written: April 2002
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.
Keywords: Currency crisis, speculative attacks, optimal policy, fixed exchange rates
JEL Classification: F31
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