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The Dynamics of Financial Crises and the Risk to Defend the Exchange Rate

  • Christian Bauer
  • Bernhard Herz

Despite major recent advance in the literature on financial crises, the key role of central banks in the dynamics of financial crises are still not well understood. Our aim is to contribute to a better understanding of the dynamics of financial crises by explicitly modeling the strategic options of both traders and central banks. We analyze a global game in which both speculative traders and the central bank face imperfect information. In case of an attack, the central bank basically faces three alternatives. It can either give in to the speculative attack or it can try to defend its exchange rate regime. If it chooses to defend its currency, the defense can be successful or not. In accordance with stylized facts for emerging markets, immediate devaluations are associated with costs in terms of higher (imported) inflation, successful interventions are followed by sluggish growth due to the underlying restrictive monetary policy while unsuccessful interventions typically result in both high inflation and a recession. Taken together, intervention is risky. If a central bank chooses to defend its currency it can avoid the costs of a devaluation in case the defense is successful. However, if it fails it faces the even higher costs of an (unsuccessful) defense and a devaluation, i.e. higher inflation and lower growth. In our global game approach, the strength of the realized defensive measures - in contrast to the potential defense - in general does not monotonously increase with the fundamental state. Thus global games attack models need to take into account the difference between the fundamentals themselves .i.e. the strength of the status quo or the defensive potential .and the optimal central bank reaction to an attack, i.e. the realized defensive measures.

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Paper provided by University of Trier, Department of Economics in its series Research Papers in Economics with number 2009-03.

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Length: 32 pages
Date of creation: 2009
Date of revision:
Handle: RePEc:trr:wpaper:200903
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  1. M. Sbracia & Alessandro Prati, 2002. "Currency Crises and Uncertainty About Fundamentals," IMF Working Papers 02/3, International Monetary Fund.
  2. Aaron Tornell & Frank Westermann, 2005. "Boom-Bust Cycles and Financial Liberalization," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262201593, June.
  3. Herz, Bernhard & Bauer, Christian & Karb, Volker, 2006. "Are twin currency and debt crises special?," Proceedings of the German Development Economics Conference, Berlin 2006 11, Verein für Socialpolitik, Research Committee Development Economics.
  4. Lars E. O. Svensson, 2006. "Social Value of Public Information: Comment: Morris and Shin (2002) Is Actually Pro-Transparency, Not Con," American Economic Review, American Economic Association, vol. 96(1), pages 448-452, March.
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  6. Stephen Morris & Hyun Song Shin, 1999. "Coordination Risk and the Price of Debt," Cowles Foundation Discussion Papers 1241R, Cowles Foundation for Research in Economics, Yale University, revised Feb 2002.
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  10. Christophe Chamley, 2003. "Dynamic Speculative Attacks," American Economic Review, American Economic Association, vol. 93(3), pages 603-621, June.
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  12. Christian Bauer, 2005. "Solution Uniqueness In A Class Of Currency Crisis Games," International Game Theory Review (IGTR), World Scientific Publishing Co. Pte. Ltd., vol. 7(04), pages 531-543.
  13. George-Marios Angeletos & Alessandro Pavan & Christian Hellwig, 2007. "Defense Policies Against Currency Attacks: on the Possibility of Predictions in a Global Game with Multiple Equilibria," Discussion Papers 1459, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  14. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August.
  15. George-Marios Angeletos & Christian Hellwig & Alessandro Pavan, 2007. "Dynamic Global Games of Regime Change: Learning, Multiplicity, and the Timing of Attacks," Econometrica, Econometric Society, vol. 75(3), pages 711-756, 05.
  16. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
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