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Arbitrage mechanism leading to currency crises: a theoretical perspective

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  • Lilia Cavallari
  • Giancarlo Corsetti

Abstract

In his seminal contribution on exchange rate crises, Krugman models speculative attacks as optimal market reactions to policy rules that are inconsistent with the indefinite survival of a fixed nominal parity. Later contributions have shifted the focus of the analysis, modelling exchange rate crises as rational decisions by optimizing policy makers to abandon the peg. This paper analyzes the logical core of the two modelling strategies in terms of arbitrage. We use a generalized version of the arbitrage rule first discussed by Flood and Garber, that expresses the conditions for a crisis to occur in the metric of the shadow exchange rate. Our arbitrage-based methodology of analysis can be applied to virtually all models of exchange rate crises.

Suggested Citation

  • Lilia Cavallari & Giancarlo Corsetti, 1997. "Arbitrage mechanism leading to currency crises: a theoretical perspective," Working Papers in Public Economics 28, Department of Economics and Law, Sapienza University of Roma.
    • Handle: RePEc:sap:wpaper:wp28
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    References listed on IDEAS

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    1. Buiter, Willem H. & Corsetti, Giancarlo & Pesenti, Paolo, 1995. "A Centre-Periphery Model of Monetary Coordination and Exchange Rate Crises," CEPR Discussion Papers 1201, C.E.P.R. Discussion Papers.
    2. William Poole, 1969. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Special Studies Papers 2, Board of Governors of the Federal Reserve System (U.S.).
    3. Allan Drazen & Paul R. Masson, 1994. "Credibility of Policies Versus Credibility of Policymakers," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(3), pages 735-754.
    4. Buiter, Willem H., 1987. "Borrowing to defend the exchange rate and the timing and magnitude of speculative attacks," Journal of International Economics, Elsevier, vol. 23(3-4), pages 221-239, November.
    5. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
    6. Maurice Obstfeld & Kenneth Rogoff, 1995. "The Mirage of Fixed Exchange Rates," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 73-96, Fall.
    7. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
    8. Grilli, Vittorio U., 1986. "Buying and selling attacks on fixed exchange rate systems," Journal of International Economics, Elsevier, vol. 20(1-2), pages 143-156, February.
    9. Robert P. Flood & Jagdeep S. Bhandari & Jocelyn P. Horne, 1989. "Evolution of Exchange Rate Regimes," IMF Staff Papers, Palgrave Macmillan, vol. 36(4), pages 810-835, December.
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    11. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-325, August.
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    13. Isard,Peter, 1995. "Exchange Rate Economics," Cambridge Books, Cambridge University Press, number 9780521460477, November.
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    More about this item

    Keywords

    Balance of payment crises; Speculative attack; Devaluation; Fixed exchange rate; multiple equilibria.;
    All these keywords.

    JEL classification:

    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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