Working Paper: CEPR ID: DP879
Authors: F. Gulcin Ozkan; Alan Sutherland
Abstract: Existing models of exchange rate crises do not provide a good explanation for the breakdown of the ERM in 19923. 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 is triggered by an optimizing government that 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. 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.
Keywords: Speculative attacks; Balance of payments crises; EMS; ERM
JEL Codes: F31; F32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| foreign interest rates (E43) | domestic interest rates (E43) |
| domestic interest rates (E43) | output (C67) |
| foreign interest rates (E43) | expectation of regime switch (P27) |
| expectation of regime switch (P27) | domestic interest rates (E43) |
| government preferences (D72) | regime switch (E63) |
| interaction between private sector expectations and government preferences (D84) | breakdown of fixed exchange rate regime (F31) |
| government capacity to maintain fixed rate (E52) | regime switch (E63) |
| credibility problem (E51) | earlier regime switch (P39) |