A Model of the ERM Crisis
Existing models of speculative attacks and balance of payments crises do not provide a good explanation for the breakdown of the ERM in 1992/93. This paper presents an alternative model which captures some of the important features of that period. The switch from a fixed to a floating rate regime is triggered, in this model, by an optimising government which wants to loosen monetary policy and boost aggregate demand. Agents in the foreign exchange market know the government's objective function and therefore build expectations of a regime switch into interest differentials. The resulting rise in interest rates affects the government's decision to switch regime (via the effect of interest rates on aggregate demand). It is shown that this interaction between private sector expectations and government preferences can imply a breakdown of the fixed rate sooner than the government would like.
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