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Carry Trades, Monetary Policy and Speculative Dynamics

  • Plantin, Guillaume
  • Shin, Hyun Song

We ask when currency carry trades are associated with destabilizing dynamics in the foreign exchange market, and investigate the role of monetary policy rules in setting of such dynamics. In a model where the exchange rate has a long-term fundamental anchor, we find that carry trades can be stabilizing or destabilizing at shorter horizons, depending on the propensity of capital inflows to overheat the recipient economy. In the destabilizing case, we solve for a unique equilibrium that exhibits the classic pattern of the carry trade recipient currency appreciating for extended periods, punctuated by sharp falls.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8224.

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Date of creation: Feb 2011
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Handle: RePEc:cpr:ceprdp:8224
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  1. Carlsson, H. & Van Damme, E., 1990. "Global Games And Equilibrium Selection," Papers 9052, Tilburg - Center for Economic Research.
  2. Francis Breedon, 2001. "Market liquidity under stress: observations from the FX market," BIS Papers chapters, in: Bank for International Settlements (ed.), Market liquidity: proceedings of a workshop held at the BIS, volume 2, pages 149-151 Bank for International Settlements.
  3. Emmanuel Farhi & Xavier Gabaix, 2008. "Rare Disasters and Exchange Rates," NBER Working Papers 13805, National Bureau of Economic Research, Inc.
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