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Coordination and Policy Traps

  • George-Marios Angeletos
  • Christian Hellwig
  • Alessandro Pavan

This paper examines the ability of a policy maker to control equilibrium outcomes in an environment where market participants play a coordination game with information heterogeneity. We consider defense policies against speculative currency attacks in a model where speculators observe the fundamentals with idiosyncratic noise. The policy maker is willing to take a costly policy action only for moderate fundamentals. Market participants can use this information to coordinate on di.erent responses to the same policy action, thus resulting in policy traps, where the devaluation outcome and the shape of the optimal policy are dictated by self-fulfilling market expectations. Despite equilibrium multiplicity, robust policy predictions can be made. The probability of devaluation is monotonic in the fundamentals, the policy maker adopts a costly defense measure only for a small region of moderate fundamentals, and this region shrinks as the information in the market becomes precise.

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File URL: http://www.nber.org/papers/w9767.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9767.

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Date of creation: Jun 2003
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Publication status: published as Angeletos, George-Marios, C. Hellwig and A. Pavan. "Signaling in a Global Game: Coordination and Policy Traps." Journal of Political Economy 114, 3 (June 2006): 452-486.
Handle: RePEc:nbr:nberwo:9767
Note: EFG IFM
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