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A Center-Periphery Model of Monetary Coordination and Exchange Rate Crises

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  • Willem H. Buiter
  • Giancarlo Corsetti
  • Paolo A. Pesenti

Abstract

The paper analyzes the modalities and consequences of a breakdown of cooperation between the monetary authorities of inflation-prone Periphery Countries that use an exchange rate peg as an anti- inflationary device, when the Center is hit by an aggregate demand shock. Cooperation in the Periphery is constrained to be symmetric: costs and benefits must be equal for all. Our model suggests that there are at least two ways in which a generalized crisis of the exchange rate system may emerge. The first is when the constrained cooperative response of the Periphery is a moderate common devaluation while the non-cooperative equilibrium has large devaluations by a few countries. An exchange rate crisis emerges if Periphery countries give in to their individual incentives to renege on the cooperative agreement. In the second case, the Center shock is not large enough to trigger a general devaluation in the constrained cooperative equilibrium; yet some of the Periphery countries would devalue in the Nash equilibrium, making the monetary stance in the system more expansionary. In this case, reversion to Nash is collectively rational. We offer this model as a useful parable for interpreting the collapse of the EMR in 1992-93.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5140.

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Date of creation: Jun 1995
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Publication status: published as Financial Markets and European Monetary Cooperation: The Lessons of the 92-93 ERM Crisis, Cambridge University Press, 1998.
Handle: RePEc:nbr:nberwo:5140

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  1. Obstfeld, Maurice, 1986. "Rational and Self-fulfilling Balance-of-Payments Crises," American Economic Review, American Economic Association, American Economic Association, vol. 76(1), pages 72-81, March.
  2. Ozkan, F. Gulcin & Sutherland, Alan, 1998. "A currency crisis model with an optimising policymaker," Journal of International Economics, Elsevier, Elsevier, vol. 44(2), pages 339-364, April.
  3. Gerlach, Stefan & Smets, Frank, 1994. "Contagious Speculative Attacks," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1055, C.E.P.R. Discussion Papers.
  4. Ozkan, F Gulcin & Sutherland, Alan, 1995. "Policy Measures to Avoid a Currency Crisis," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 105(429), pages 510-19, March.
  5. Maurice Obstfeld, 1991. "Destabilizing Effects of Exchange-Rate Escape Clauses," NBER Working Papers 3603, National Bureau of Economic Research, Inc.
  6. Masson, Paul R, 1995. "Gaining and Losing ERM Credibility: The Case of the United Kingdom," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 105(430), pages 571-82, May.
  7. Persson, Torsten & Tabellini, Guido, 1995. "Double-edged incentives: Institutions and policy coordination," Handbook of International Economics, Elsevier, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 38, pages 1973-2030 Elsevier.
  8. de Kock, Gabriel & Grilli, Vittorio, 1993. "Fiscal Policies and the Choice of Exchange Rate Regime," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 103(417), pages 347-58, March.
  9. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 11(3), pages 311-25, August.
  10. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
  11. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, December.
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