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Rational Speculation, Financial Crises, and Optimal Policy Responses

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  • Jay Surti

Abstract

This paper develops a theory of the onset of financial crises by solving for the optimal trading strategies of speculators in financial markets, in a model where each speculator tries to coordinate her trades with the market's by observing the decisions of other speculators, while simultaneously trying to preempt the market. The interaction and resolution of these two conflicting incentives are analyzed under alternate central bank policy regimes. Our model explains how imperfect information structures prevent traders from exploiting profitable opportunities and suggests how large traders help alleviate this problem by undertaking risky arbitrage early in the investment process, in return for higher profits, if successful. The central bank's defense strategy is a parameter of this model. We compare the likelihood of a crisis under alternate defense strategies and show that credible monetary authorities can provide a better defense of exchange rate regimes against adverse shocks by not disclosing their commitment value to the market.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 04/25.

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Length: 28
Date of creation: 01 Feb 2004
Date of revision:
Handle: RePEc:imf:imfwpa:04/25

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Related research

Keywords: Central bank policy; Markets; Economic models;

This paper has been announced in the following NEP Reports:

References

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  1. Gale, Douglas, 1995. "Dynamic Coordination Games," Economic Theory, Springer, vol. 5(1), pages 1-18, January.
  2. Christophe Chamley, 2003. "Dynamic Speculative Attacks," American Economic Review, American Economic Association, vol. 93(3), pages 603-621, June.
  3. Gale, D. & Chamley, C., 1992. "Information Revelation and Strategic Delay in a Model of Investment," Papers 10, Boston University - Department of Economics.
  4. Markus K Brunnermeier, 2002. "Bubbles and Crashes," FMG Discussion Papers dp401, Financial Markets Group.
  5. Aaron Tornell, 1999. "Common Fundamentals in the Tequila and Asian Crises," Harvard Institute of Economic Research Working Papers 1868, Harvard - Institute of Economic Research.
  6. Bulow, Jeremy & Klemperer, Paul, 1994. "Rational Frenzies and Crashes," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 1-23, February.
  7. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
  8. Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, MIT Press, vol. 103(3), pages 441-63, August.
  9. Peter M. Garber & Michael G. Spencer, 1994. "Foreign Exchange Hedging with Synthetic Options and the Interest Rate Defense of a Fixed Exchange Rate Regime," IMF Working Papers 94/151, International Monetary Fund.
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