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Expectations and contagion in self-fulfilling currency attacks

  • Todd Keister

This paper presents a model in which currency crises can spread across countries as a result of the self-fulfilling beliefs of market participants. An incomplete-information approach is used to overcome many undesirable features of existing multiple-equilibrium explanations of contagion. If speculators expect contagion across markets to occur, they have an incentive to trade in both currency markets to take advantage of this correlation. These actions, in turn, link the two markets in such a way that a sharp devaluation of one currency will be propagated to the other market, fulfilling the original expectations. Even though this contagion is driven solely by expectations, the model places restrictions on observable variables that are broadly consistent with existing empirical evidence.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 249.

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Date of creation: 2006
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Handle: RePEc:fip:fednsr:249
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