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The Dynamics of Financial Crises and the Risk to Defend the Exchange Rate

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Author Info

  • Christian Bauer
  • Bernhard Herz

Abstract

Despite major recent advance in the literature on financial crises, the key role of central banks in the dynamics of financial crises are still not well understood. Our aim is to contribute to a better understanding of the dynamics of financial crises by explicitly modeling the strategic options of both traders and central banks. We analyze a global game in which both speculative traders and the central bank face imperfect information. In case of an attack, the central bank basically faces three alternatives. It can either give in to the speculative attack or it can try to defend its exchange rate regime. If it chooses to defend its currency, the defense can be successful or not. In accordance with stylized facts for emerging markets, immediate devaluations are associated with costs in terms of higher (imported) inflation, successful interventions are followed by sluggish growth due to the underlying restrictive monetary policy while unsuccessful interventions typically result in both high inflation and a recession. Taken together, intervention is risky. If a central bank chooses to defend its currency it can avoid the costs of a devaluation in case the defense is successful. However, if it fails it faces the even higher costs of an (unsuccessful) defense and a devaluation, i.e. higher inflation and lower growth. In our global game approach, the strength of the realized defensive measures - in contrast to the potential defense - in general does not monotonously increase with the fundamental state. Thus global games attack models need to take into account the difference between the fundamentals themselves .i.e. the strength of the status quo or the defensive potential .and the optimal central bank reaction to an attack, i.e. the realized defensive measures.

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File URL: http://www.uni-trier.de/fileadmin/fb4/prof/VWL/EWF/Research_Papers/2009-03.pdf
File Function: First version, 2009
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Bibliographic Info

Paper provided by University of Trier, Department of Economics in its series Research Papers in Economics with number 2009-03.

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Length: 32 pages
Date of creation: 2009
Date of revision:
Handle: RePEc:trr:wpaper:200903

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Keywords: currency crises; monetary policy; global game; imperfect information;

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References

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  1. Robin Pope & Reinhard Selten & Sebastian Kube & Johannes Kaiser & Jürgen von Hagen, 2007. "Exchange Rate Determination: A Model of the Decisive Role of Central Bank Cooperation and Conflict," Bonn Econ Discussion Papers, University of Bonn, Germany bgse18_2007, University of Bonn, Germany.
  2. Alessandro Prati & Massimo Sbracia, 2002. "Currency crises and uncertainty about fundamentals," Temi di discussione (Economic working papers), Bank of Italy, Economic Research and International Relations Area 446, Bank of Italy, Economic Research and International Relations Area.
  3. Aaron Tornell & Frank Westermann, 2005. "Boom-Bust Cycles and Financial Liberalization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262201593, December.
  4. Christian Bauer & Bernhard Herz & Volker Karb, 2006. "Are twin currency and debt crises special?," Working Papers, Bavarian Graduate Program in Economics (BGPE) 019, Bavarian Graduate Program in Economics (BGPE).
  5. Ho, Tai-Kuang & von Hagen, Jürgen, 2004. "Money Market Pressure and the Determinants of Banking Crises," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4651, C.E.P.R. Discussion Papers.
  6. Lars E. O. Svensson, 2006. "Social Value of Public Information: Comment: Morris and Shin (2002) Is Actually Pro-Transparency, Not Con," American Economic Review, American Economic Association, American Economic Association, vol. 96(1), pages 448-452, March.
  7. Frank Heinemann & Rosemarie Nagel & Peter Ockenfels, 2004. "The Theory of Global Games on Test: Experimental Analysis of Coordination Games with Public and Private Information," Econometrica, Econometric Society, Econometric Society, vol. 72(5), pages 1583-1599, 09.
  8. Stephen Morris & Hyun Song Shin, 2001. "Coordination risk and the price of debt," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 25046, London School of Economics and Political Science, LSE Library.
  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. Frankel, Jeffrey A. & Rose, Andrew K., 1996. "Currency crashes in emerging markets: An empirical treatment," Journal of International Economics, Elsevier, Elsevier, vol. 41(3-4), pages 351-366, November.
  11. Christophe Chamley, 2003. "Dynamic Speculative Attacks," American Economic Review, American Economic Association, American Economic Association, vol. 93(3), pages 603-621, June.
  12. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
  13. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, American Economic Association, vol. 92(5), pages 1521-1534, December.
  14. George-Marios Angeletos & Christian Hellwig & Alessandro Pavan, 2007. "Dynamic Global Games of Regime Change: Learning, Multiplicity, and the Timing of Attacks," Econometrica, Econometric Society, Econometric Society, vol. 75(3), pages 711-756, 05.
  15. Christian Bauer, 2005. "Solution Uniqueness In A Class Of Currency Crisis Games," International Game Theory Review (IGTR), World Scientific Publishing Co. Pte. Ltd., World Scientific Publishing Co. Pte. Ltd., vol. 7(04), pages 531-543.
  16. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, Elsevier, vol. 17(1-2), pages 1-13, August.
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Cited by:
  1. Christian Bauer & Philip Ernstberger, 2014. "The Dynamics of Currency Crises---Results from Intertemporal Optimization and Viscosity Solutions," Research Papers in Economics 2014-06, University of Trier, Department of Economics.

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