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Bayesian Capital Markets and Currency Crises

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  • Alexis Derviz

Abstract

The paper presents a theoretical model of the foreign exchange markets in the transition economies in EastCentral Europe in the last 2-3 years. The main feature of transformation is privatization process on the one hand, and a gradual liberalization of capital and foreign exchange flows on the other. The object of our interest is the value of the currency unit of a transition economy in international terms. The aim of the model is to identify equilibrium trajectories of the exchange rate resulting from strategic interaction of a number of international investors who act on all domestic capital markets including the foreign exchange market, and the central bank. The investors are portfolio optimizers who choose between risky investments in bonds, equity or liquidity inside the country and riskless foreign bonds. The central bank is modeled as an agent with three objectives: stable exchange rate, sufficient level of foreign reserves, and non-inflationary money supply. The instruments of the central bank are interventions in the foreign exchange market, regulations of the quantity of money through operations on the bond market, and regulations of the interest rate. We find that as long as the privatization process generates a continuous supply of new equity with a positive impact on the performance of the economy, the usual incentives of investors to speculate with the domestic currency can be dominated by a stronger incentive to hold the currency for future domestic investment. This situation can be disrupted if the central bank conducts a policy inconsistent with the general economic stabilization. That is, deviations from what is generally considered a rational behavior of the central bank, are penalized by capital markets. For this reason, imitating the policies of the European Monetary System, such as an absolute commitment to protect a pre-announced target zone for the exchange rate, can have negative consequences for transitional and post-transitional economies.

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Bibliographic Info

Article provided by The Czech Econometric Society in its journal Bulletin of the Czech Econometric Society.

Volume (Year): 2 (1995)
Issue (Month): 3 ()
Pages:

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Handle: RePEc:czx:journl:v:2:y:1995:i:3:id:23

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