How to avoid self-fulfilling crises
Obstfeld (1994) shows that, for the same level of economic fundamentals, it may be optimal for a government either to devalue or to maintain the peg. Multiple equilibria occur: it is the phenomenon of self-fulfilling crisis. To avoid this kind of crisis, this article offers a new proposal: a partial delegation of exchange rate policy to a more inflation-averse central banker. It shows that if the government continues to decide whether to maintain the peg while the central banker chooses the magnitude of any realignment, lower inflationary expectations will lead to the existence of only one equilibrium.
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