Working Paper: CEPR ID: DP3714
Authors: Alex Cukierman; Itay Goldstein; Yossi Spiegel
Abstract: We develop a framework for studying the choice of exchange rate regime in an open economy where the local currency is vulnerable to speculative attacks. The framework makes it possible to study, for the first time, the strategic interaction between the ex ante choice of regime and the probability of ex post currency attacks. The optimal regime is determined by a policymaker who trades off the loss from nominal exchange rate uncertainty against the cost of maintaining a given regime. This cost is affected in turn by the likelihood of a speculative attack. Searching for the optimal regime within the class of exchange rate bands, we show that the optimal regime is either a peg (a zero-width band), a free float (an infinite-width band), or a non-degenerate finite-width band. Our framework generates several novel predictions and shows that when the endogeneity of the exchange rate regime is recognized explicitly, conventional wisdom may be reversed. For instance, the imposition of a Tobin tax, by inducing policymakers to set less flexible regimes, may raise the likelihood of speculative attacks.
Keywords: choice of exchange rate regime; currency crises; global games; reputation; speculators; Tobin tax
JEL Codes: F30; F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| choice of exchange rate regime (F33) | likelihood of speculative attacks (D84) |
| policymaker's aversion to uncertainty (D81) | choice of narrower band (D79) |
| choice of narrower band (D79) | behavior of speculators (D84) |
| behavior of speculators (D84) | likelihood of currency crisis (F31) |
| imposition of Tobin tax (H87) | likelihood of attacks (H56) |
| imposition of Tobin tax (H87) | choice of narrower bands (D79) |
| choice of narrower bands (D79) | likelihood of currency crisis (F31) |