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Defending Against Speculative Attacks

  • Tijmen Daniëls
  • Henk Jager
  • Franc Klaassen

While virtually all currency crisismodels recognise that the fate of a currency peg depends on how tenaciously policy makers defend it, they seldom model how this is done. We incorporate themechanics of speculation and the interest rate defence against it in the model ofMorris and Shin (American Economic Review 88, 1998). Our model captures that the interest rate defence reduces speculators’ profits and thus postpones the crisis. It predicts that well before the fall of a currency interest rates are increased to offset the buildup of exchange market pressure, and this then unravels in a sharp depreciation. This pattern is at odds with predictions of standard models, but we show that it fits well with reality.

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Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2009-011.

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Length: 34 pages
Date of creation: Feb 2009
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Handle: RePEc:hum:wpaper:sfb649dp2009-011
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