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When Are Fixed Exchange Rates Really Fixed?

  • Andres Velasco
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    This paper analyzes the sustainability of fixed exchange rates by extending the Barro-Gordon framework to a fully dynamic context in which the level of a state variable (in this case debt) determines the payoffs available to the government at each point in time. The model yields the following results. If debt is sufficiently low, there is an equilibrium in which the government does not devalue. For an intermediate range of debt levels, the government devalues in response to an attack but not otherwise, so that self-fulfilling attacks can occur. Finally, for yet another debt range there can also be sunspot equilibria in which an attack (and the corresponding devaluation) occurs with positive probability.

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    File URL: http://www.nber.org/papers/w5842.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5842.

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    Date of creation: Nov 1996
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    Publication status: published as Journal of Development Economics, Vol. 54, no. 1 (October 1997): 5-25.
    Handle: RePEc:nbr:nberwo:5842
    Note: IFM
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    National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.

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    1. Pierre-Richard Agénor & Jagdeep S. Bhandari & Robert P. Flood, 1992. "Speculative Attacks and Models of Balance of Payments Crises," IMF Staff Papers, Palgrave Macmillan, vol. 39(2), pages 357-394, June.
    2. Velasco, Andres, 1994. "Are Balance of Payments Crises Rational?," Working Papers 94-08, C.V. Starr Center for Applied Economics, New York University.
    3. Tornell, Aaron & Velasco, Andres, 2000. "Fixed versus flexible exchange rates: Which provides more fiscal discipline?," Journal of Monetary Economics, Elsevier, vol. 45(2), pages 399-436, April.
    4. Harold L. Cole & Timothy J. Kehoe, 1998. "Self-fulfilling debt crises," Staff Report 211, Federal Reserve Bank of Minneapolis.
    5. Bensaid, Bernard & Jeanne, Olivier, 1997. "The instability of fixed exchange rate systems when raising the nominal interest rate is costly," European Economic Review, Elsevier, vol. 41(8), pages 1461-1478, August.
    6. Pierre-Richard Agenor & Jagdeep S. Bhandari & Robert P. Flood, 1991. "Speculative Attacks and Models of Balance-of-Payments Crises," NBER Working Papers 3919, National Bureau of Economic Research, Inc.
    7. Obstfeld, Maurice, 1991. "Destabilizing Effects of Exchange-Rate Escape Clauses," CEPR Discussion Papers 518, C.E.P.R. Discussion Papers.
    8. Gulcin Ozkan & Alan Sutherland, . "A Currency Crisis Model with an Optimising Policymaker," Discussion Papers 96/11, Department of Economics, University of York.
    9. Obstfeld, Maurice, 1986. "Rational and Self-fulfilling Balance-of-Payments Crises," American Economic Review, American Economic Association, vol. 76(1), pages 72-81, March.
    10. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 627-656, October.
    11. Ozkan, F Gulcin & Sutherland, Alan, 1995. "Policy Measures to Avoid a Currency Crisis," Economic Journal, Royal Economic Society, vol. 105(429), pages 510-19, March.
    12. Horn, Henrik & Persson, Torsten, 1988. "Exchange rate policy, wage formation and credibility," European Economic Review, Elsevier, vol. 32(8), pages 1621-1636, October.
    13. Chari, V V & Kehoe, Patrick J, 1990. "Sustainable Plans," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 783-802, August.
    14. de Kock, Gabriel & Grilli, Vittorio, 1993. "Fiscal Policies and the Choice of Exchange Rate Regime," Economic Journal, Royal Economic Society, vol. 103(417), pages 347-58, March.
    15. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-71, October.
    16. Kenneth Rogoff, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, Oxford University Press, vol. 100(4), pages 1169-1189.
    17. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
    18. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
    19. Michael W. Klein & Nancy P. Marion, 1994. "Explaining the Duration of Exchange-Rate Pegs," NBER Working Papers 4651, National Bureau of Economic Research, Inc.
    20. Allan Drazen & Paul R. Masson, 1993. "Credibility of Policies versus Credibility of Policymakers," NBER Working Papers 4448, National Bureau of Economic Research, Inc.
    21. Maurice Obstfeld, 1994. "The Logic of Currency Crises," NBER Working Papers 4640, National Bureau of Economic Research, Inc.
    22. Drew Fudenberg & Jean Tirole, 1991. "Game Theory," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061414, March.
    23. Cukierman, Alex & Leiderman, Leonardo & Spiegel, Yossi, 1994. "Choosing the Width of Exchange Rate Bands - Credibility vs. Flexibility," CEPR Discussion Papers 907, C.E.P.R. Discussion Papers.
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