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Rational Speculation, Financial Crises, and Optimal Policy Responses


  • Jay Surti


This paper develops a theory of the onset of financial crises by solving for the optimal trading strategies of speculators in financial markets, in a model where each speculator tries to coordinate her trades with the market's by observing the decisions of other speculators, while simultaneously trying to preempt the market. The interaction and resolution of these two conflicting incentives are analyzed under alternate central bank policy regimes. Our model explains how imperfect information structures prevent traders from exploiting profitable opportunities and suggests how large traders help alleviate this problem by undertaking risky arbitrage early in the investment process, in return for higher profits, if successful. The central bank's defense strategy is a parameter of this model. We compare the likelihood of a crisis under alternate defense strategies and show that credible monetary authorities can provide a better defense of exchange rate regimes against adverse shocks by not disclosing their commitment value to the market.

Suggested Citation

  • Jay Surti, 2004. "Rational Speculation, Financial Crises, and Optimal Policy Responses," IMF Working Papers 04/25, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:04/25

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    References listed on IDEAS

    1. Dilip Abreu & Markus K. Brunnermeier, 2003. "Bubbles and Crashes," Econometrica, Econometric Society, vol. 71(1), pages 173-204, January.
    2. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
    3. Christophe Chamley, 2003. "Dynamic Speculative Attacks," American Economic Review, American Economic Association, vol. 93(3), pages 603-621, June.
    4. Russell Cooper & Andrew John, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics, Oxford University Press, vol. 103(3), pages 441-463.
    5. Bulow, Jeremy & Klemperer, Paul, 1994. "Rational Frenzies and Crashes," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 1-23, February.
    6. Gale, Douglas, 1995. "Dynamic Coordination Games," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 5(1), pages 1-18, January.
    7. Aaron Tornell, 1999. "Common Fundamentals in the Tequila and Asian Crises," Harvard Institute of Economic Research Working Papers 1868, Harvard - Institute of Economic Research.
    8. Chamley, Christophe & Gale, Douglas, 1994. "Information Revelation and Strategic Delay in a Model of Investment," Econometrica, Econometric Society, vol. 62(5), pages 1065-1085, September.
    9. Peter M. Garber & Michael G. Spencer, 1994. "Foreign Exchange Hedging with Synthetic Options and the Interest Rate Defense of a Fixed Exchange Rate Regime," IMF Working Papers 94/151, International Monetary Fund.
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