Self-Fulfilling Risk Predictions: An Application to Speculative Attacks
34 Pages Posted: 15 Feb 2006
Date Written: August 1998
The paper shows that changing market beliefs about currency risk can generate a self-fulfilling speculative attack on a fixed exchange rate. The attack does not require a later change in policies to make it profitable. This is illustrated by introducing an endogenous risk premium into a "first-generation model" of a speculative attack. The model is further modified to take account of sterilization, debt-financed fiscal deficits, and anticipatory price-setting behavior. The model is used to interpret the 1994 Mexican peso crisis.
Keywords: Currency crisis, devaluation, risk premium, Mexico
JEL Classification: F3, F4
Suggested Citation: Suggested Citation