Self-Fulfilling Currency Crises: The Role of Interest Rates

32 Pages Posted: 8 Apr 2005 Last revised: 1 Aug 2010

See all articles by Christian Hellwig

Christian Hellwig

University of Toulouse 1 - Toulouse School of Economics (TSE)

Arijit Mukherji

Deceased

Aleh Tsyvinski

Harvard University - Department of Economics; New Economic School (NES)

Date Written: March 2005

Abstract

We develop a stylized currency crises model with heterogeneous information among investors and endogenous determination of interest rates in a noisy rational expectations equilibrium. Our model captures three key features of interest rates: the opportunity cost of attacking the currency responds to the investors' behavior; the domestic interest rate may influence the central bank's preferences for a fixed exchange rate; and the domestic interest rate serves as a public signal which aggregates private information about fundamentals. We explore the payoff and informational channels through which interest rates determine devaluation outcomes, and examine the implications for equilibrium selection by global games methods. Our main conclusion is that multiplicity is not an artifact of common knowledge. In particular, we show that multiplicity emerges robustly, either when a devaluation is triggered by the cost of high domestic interest rates as in Obstfeld (1996), or when a devaluation is triggered by the central bank's loss of foreign reserves as in Obstfeld (1986), provided that the domestic asset supply is sufficiently elastic in the interest rate and shocks to the domestic bond supply are sufficiently small.

Suggested Citation

Hellwig, Christian and Mukherji, Arijit and Tsyvinski, Aleh, Self-Fulfilling Currency Crises: The Role of Interest Rates (March 2005). NBER Working Paper No. w11191. Available at SSRN: https://ssrn.com/abstract=684717

Christian Hellwig

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

Arijit Mukherji

Deceased

N/A

Aleh Tsyvinski (Contact Author)

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

New Economic School (NES) ( email )

100A Novaya Street
Moscow, Skolkovo 143026
Russia

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