Models with Self-Fulfilling Features (Obstfeld 1996)

Topics: Inflation, Currency, Macroeconomics Pages: 3 (815 words) Published: March 21, 2013
Models of Currency Crises with Self-Fulfilling Features (Obstfeld 1996) Introduction
* EMS (European Monetary System) currencies were subject to speculative attacks from 1992 to 1993 * fluctuation bands of the EMS currencies with respect to the Deutschmark had been widened from ± 2.25% around par to ± 15% in August 1993 * Surprisingly the French Franc, Belgian franc and Danish krone traded not far from their original lower bands in the following years, even though there their unemployment rates and debt to GDP ratios remained high.

* These findings are opposing to classical theories of rational speculative attacks: * Through inflation a Balance of Payments deficit emerges * Speculators trigger these developments by shorting domestic currency * Eventually the currency is freed in order to depreciate * This implies that the currency-peg was unsustainable.

* No evidence that the currency-peg was unsustainable by the time speculators attacked * Suggests that even sustainable currency pegs may be attacked and even broken * Calls for a new theory in which the focus is on the government’s continuous comparison of the costs and benefits of defending the exchange rate Strategic Foundations

* Even sustainable pegged exchange rates may be defeated by market sentiment * Macroeconomic fundamentals determine the range of possible equilibria

* There are two foreign-exchange traders
* Government holds a certain amount of foreign reserves
* The pay-off matrix in each of the three games is determined by the amount of foreign reserves held by the government and used to defend the peg * If reserves are high the traders have no chance in freeing the * For the low reserve game there is an equilibrium in strictly dominated strategies for (sell,sell) * For the intermediate reserve game there are two equilibria at either (hold,hold) or (sell,sell) * Thus that equilibrium is self-fulfilling and a...
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