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Expectations and Contagion in Self-Fulfilling Currency Attacks

  • Tood Keister

    ()

    (Centro de Investigacion Economica (CIE), Instituto Tecnologico Autonomo de Mexico (ITAM))

This paper shows how expectations-driven contagion of currency crises can arise even if the currency market has a unique equilibrium when viewed in isolation. The model of Morris and Shin (1998) is extended to allow speculators to trade in a second currency market. If speculators believe that a devaluation of this other currency will make a domestic devaluation more likely, they will engage in trades that link the two markets. A sharp devaluation of the other currency will then be propagated to the domestic market and will increase the likelihood of a crisis there, fulfilling the original expectations. Even though this contagion is driven solely by expectations, the model places restrictions on observable variables, and these restrictions are broadly consistent with existing empirical evidence.

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File URL: http://ftp.itam.mx/pub/academico/inves/keister/05-01.pdf
File Function: First version, 2005
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Paper provided by Centro de Investigacion Economica, ITAM in its series Working Papers with number 0501.

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Length: 22 pages
Date of creation: Apr 2005
Date of revision:
Handle: RePEc:cie:wpaper:0501
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  1. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
  2. Carlsson, H. & Van Damme, E., 1990. "Global Games And Equilibrium Selection," Papers 9052, Tilburg - Center for Economic Research.
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  12. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
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  14. Eichengreen, Barry & Rose, Andrew & Wyplosz, Charles, 1996. " Contagious Currency Crises: First Tests," Scandinavian Journal of Economics, Wiley Blackwell, vol. 98(4), pages 463-84, December.
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  18. Franklin Allen & Douglas Gale, 2000. "Financial Contagion," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 1-33, February.
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  20. Laura E. Kodres & Matthew Pritsker, 2002. "A Rational Expectations Model of Financial Contagion," Journal of Finance, American Finance Association, vol. 57(2), pages 769-799, 04.
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  22. Van Rijckeghem, Caroline & Weder, Beatrice, 2001. "Sources of contagion: is it finance or trade?," Journal of International Economics, Elsevier, vol. 54(2), pages 293-308, August.
  23. Dornbusch, Rudiger & Park, Yung Chul & Claessens, Stijn, 2000. "Contagion: Understanding How It Spreads," World Bank Research Observer, World Bank Group, vol. 15(2), pages 177-97, August.
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  25. Amil Dasgupta, 2004. "Financial Contagion Through Capital Connections: A Model of the Origin and Spread of Bank Panics," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1049-1084, December.
  26. Guillermo A. Calvo, 1998. "Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops," Journal of Applied Economics, Universidad del CEMA, vol. 1, pages 35-54, November.
  27. Paul R Masson, 1999. "Multiple Equilibria, Contagion, and the Emerging Market Crises," IMF Working Papers 99/164, International Monetary Fund.
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  29. Frank Heinemann, 2000. "Unique Equilibrium in a Model of Self-Fulfilling Currency Attacks: Comment," American Economic Review, American Economic Association, vol. 90(1), pages 316-318, March.
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