Working Paper: NBER ID: w11191
Authors: Christian Hellwig; Arijit Mukherji; Aleh Tsyvinski
Abstract: We develop a stylized currency crises model with heterogeneous information among investors and endogenous determination of interest rates in a noisy rational expectations equilibrium. Our model captures three key features of interest rates: the opportunity cost of attacking the currency responds to the investors' behavior; the domestic interest rate may influence the central bank's preferences for a fixed exchange rate; and the domestic interest rate serves as a public signal which aggregates private information about fundamentals. We explore the payoff and informational channels through which interest rates determine devaluation outcomes, and examine the implications for equilibrium selection by global games methods. Our main conclusion is that multiplicity is not an artifact of common knowledge. In particular, we show that multiplicity emerges robustly, either when a devaluation is triggered by the cost of high domestic interest rates as in Obstfeld (1996), or when a devaluation is triggered by the central bank's loss of foreign reserves as in Obstfeld (1986), provided that the domestic asset supply is sufficiently elastic in the interest rate and shocks to the domestic bond supply are sufficiently small.
Keywords: currency crises; interest rates; multiple equilibria; financial stability
JEL Codes: E43; E44; E58; F30; F40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high domestic interest rates (E43) | increased likelihood of devaluation (F31) |
| high domestic interest rates (E43) | self-fulfilling expectations of traders (D84) |
| domestic interest rate (E43) | central bank's preference regarding maintaining fixed exchange rate (F33) |
| cost of defending fixed rate (E43) | devalue currency (F31) |
| domestic interest rate (E43) | traders' expectations and actions (D84) |
| interest rates (E43) | coordinating investment decisions (G11) |
| multiplicity of equilibria arises from interest rates (D53) | determining outcome of devaluation (F31) |