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Self-Fulfilling Currency Crises: The Role of Interest Rates

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  • Christian Hellwig
  • Arijit Mukherji
  • Aleh Tsyvinski

Abstract

We develop a stylized currency crises model with heterogeneous information among investors and endogenous determination of interest rates in a noisy rational expectations equilibrium. Our model captures three key features of interest rates: the opportunity cost of attacking the currency responds to the investors' behavior; the domestic interest rate may influence the central bank's preferences for a fixed exchange rate; and the domestic interest rate serves as a public signal which aggregates private information about fundamentals. We explore the payoff and informational channels through which interest rates determine devaluation outcomes, and examine the implications for equilibrium selection by global games methods. Our main conclusion is that multiplicity is not an artifact of common knowledge. In particular, we show that multiplicity emerges robustly, either when a devaluation is triggered by the cost of high domestic interest rates as in Obstfeld (1996), or when a devaluation is triggered by the central bank's loss of foreign reserves as in Obstfeld (1986), provided that the domestic asset supply is sufficiently elastic in the interest rate and shocks to the domestic bond supply are sufficiently small.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11191.

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Date of creation: Mar 2005
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Publication status: published as Christian Hellwig & Arijit Mukherji & Aleh Tsyvinski, 2006. "Self-Fulfilling Currency Crises: The Role of Interest Rates," American Economic Review, American Economic Association, vol. 96(5), pages 1769-1787, December.
Handle: RePEc:nbr:nberwo:11191

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  13. Nikola A. Tarashev, 2003. "Currency Crises and the Informational Role of Interest Rates," BIS Working Papers 135, Bank for International Settlements.
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  15. George-Marios Angeletos & Christian Hellwig & Alessandro Pavan, 2004. "Information Dynamics and Equilibrium Multiplicity in Global Games of Regime Change," NBER Working Papers 11017, National Bureau of Economic Research, Inc.
  16. George-Marios Angeletos & Christian Hellwig & Alessandro Pavan, 2005. "Signaling in a Global Game: Coordination and Policy Traps," Discussion Papers 1400, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
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  20. Cole, Harold L & Kehoe, Timothy J, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Wiley Blackwell, vol. 67(1), pages 91-116, January.
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