Working Paper: NBER ID: w9767
Authors: Georgemarios Angeletos; Christian Hellwig; Alessandro Pavan
Abstract: 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.
Keywords: No keywords provided
JEL Codes: C72; D82; D84; E5; E6; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fundamentals (Y20) | probability of devaluation (F31) |
| policy maker's interest rate setting (E43) | market expectations (D84) |
| market expectations (D84) | devaluation outcomes (F31) |
| information heterogeneity (D83) | effectiveness of policy interventions (F68) |
| policy maker's actions (D78) | speculators' responses (D84) |
| speculators' beliefs (D84) | equilibria (D50) |