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Optimal Exchange Rate Regimes: Sunspots, Currency Crises, and Welfare

Author

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  • Carsten Krabbe NIELSEN

    (Istituto di Politica Economica - Università Cattolica di Milano)

Abstract

In this two country OLG model there is a potential role for active governments since markets are incomplete. There are many coordinated policies (exchange rate regimes) that result in an optimal allocation if extrinsic uncertainty plays no role. However, if we take into account the possibility of sunspot equilibria, the set of optimal policies is drastically reduced. Whenever there is a possibility of influence by extrinsic uncertainty, one or both governments may seek to avoid this by intervening on the foreign exchange markets. When only one country does so, this may lead to a currency crisis, where the central bank is active and is with positive probability unsuccessful in its attempt to defend its currency. If the two countries form a monetary union, a coordinated fiscal policy is needed as a substitute for an optimal exchange rate regime.

Suggested Citation

  • Carsten Krabbe NIELSEN, 2004. "Optimal Exchange Rate Regimes: Sunspots, Currency Crises, and Welfare," Rivista Internazionale di Scienze Sociali, Vita e Pensiero, Pubblicazioni dell'Universita' Cattolica del Sacro Cuore, vol. 112(2), pages 155-194.
  • Handle: RePEc:vep:journl:y:2004:v:112:i:2:p:155-194
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    More about this item

    Keywords

    currency crisis; exchange rate policies; monetary union; OLG model; perfect currency;
    All these keywords.

    JEL classification:

    • D42 - Microeconomics - - Market Structure, Pricing, and Design - - - Monopoly
    • D60 - Microeconomics - - Welfare Economics - - - General
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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