1. Alternative post-collapse regimes

It has been assumed in the foregoing discussion that the exchange rate regime that follows the fixed rate’s collapse is a permanent float. ^15/ Although the focus of the theoretical literature has been on the transition from a fixed exchange rate to a post-collapse floating exchange rate, various alternative scenarios are suggested by actual experience. For instance, the central bank can devalue the currency (Blanco and Garber, 1986) or can decide to adopt a crawling peg regime following the breakdown of the fixed rate system (Dornbusch, 1987). ^16/ A particularly interesting case—often observed in practice, as in the case of Mexico described earlier—corresponds to a situation in which after allowing the currency to float for a certain period of time, the central bank once again returns to the foreign exchange market with the objective of fixing—at a depreciated level—the exchange rate. As a rule, one would expect the timing of a crisis to depend on the particular exchange arrangement agents expect the central bank to follow after a run on its reserve stock.

The model developed above can be modified to consider the case, as in Obstfeld (1984), of a (perfectly anticipated) temporary post-collapse period of floating followed by a new peg, and to study the effect of the length of this period on the time of occurence of the crisis. ^17/ In what follows, we study this case as an illustration of the type of modifications of the basic structure needed for an analysis of alternative post-collapse regimes. To begin with, suppose that the length of the transition period of floating, denoted by τ, and the level ${\overline{s}}_1>{\overline{s}}_0$ to which the exchange rate will be pegged at the end of transition, are known with certainty. ^18/ The time t_c at which the speculative attack occurs is calculated, as before, by a process of backward induction. However, this principle now imposes two restrictions rather than one. First, at time t_c + τ the preannounced new fixed rate ${\overline{s}}_1$ must coincide with the interim floating rate, ${\overline{s}}_1=s_{t_c}+\tau$. Second, the initial fixed rate, ${\overline{s}}_0$, must also coincide with the relevant shadow floating rate, that is,${\overline{s}}_0=s_{t_c}$. The condition ${\overline{s}}_1=s_{t_c}+\tau$ acts as a terminal condition on the exchange rate differential equation. Imposing this terminal condition requires use of the homogeneous part of the exchange rate solution.

Recall that in the last section, when the central bank’s policy was assumed to involve abandonment of the fixed rate and floating indefinitely thereafter, the shadow floating rate was given by equation (11). Now, under a transitory floating regime, the shadow rate is given by

where A is a constant to be determined. The complete solution must, therefore, specify values for both t and A. These solutions are obtained by imposing the conditions ${\overline{s}}_0=s_{t_c}$ and ${\overline{s}}_1=s_{t_c}+\tau$ on (17). ^19/ The solutions for t_c and A are

where $\mathrm{\Omega }=[({\overline{s}}_1-{\overline{s}}_0)-{\kappa }_1\gamma \mu \tau ]/(e^{\tau /\alpha }-1)$.

Equation (18a) indicates that the collapse time is linked to the magnitude of the expected devaluation (${\overline{s}}_1$ - ${\overline{s}}_0$), and the duration of the transitional float. ^20/ Crises occur earlier the greater the anticipated devaluation: equation (18) shows that the higher the anticipated post-devaluation exchange rate, the sooner the speculative attack occurs $\left(\partial t_c/\partial {\overline{s}}_1<0\right)$.^21/ The relationship between timing and the length of the floating-rate interval depends, in general, on the parameters of the model; $\partial t_c/\partial \tau <0$ for a small τ and ($\partial t_c/\partial \tau >0$ for a large τ. If the transitional float is sufficiently brief, however, a speculative attack on the domestic currency will occur as soon as the market realizes that the current exchange rate cannot be enforced indefinitely.

2. Uncertainty and the timing of a collapse

In the basic model developed above, it has been assumed that there is some binding threshold level, known by all agents, below which foreign reserves are not allowed to be depleted. The attainment of this critical level implies a permanent shift from a fixed exchange rate regime to a floating rate regime. In practice, however, agents are only imperfectly informed of central bank policies. They may not not perfectly know the threshold level of reserves which triggers the regime shift. If uncertainty about current and future government policy is prevalent, the assumption of perfect foresight may be inappropriate.

An implication of the perfect-foresight model developed above, which is contradicted by experience, concerns the behavior of the domestic nominal interest rate. In the model, the nominal interest rate stays constant until the moment the attack occurs—at which point it jumps to a new level consistent with the post-collapse regime. Uncertainty over the depreciation rate, as modeled below, may help to account for a rising interest rate in the transition period. Indeed, while specific results are sensistive to arbitrary assumptions regarding distributional assumptions of random terms, only stochastic models are consistent with the large interest rate fluctuations observed in actual crises.

Uncertainty in the theory of balance-of-payments crises has been introduced in various forms, but has focused on two aspects: first, uncertainty regarding the reserve limit that triggers the crisis; and second, uncertainty regarding domestic credit growth.

In practice, investors are uncertain about how much of its potential reserves the central bank is willing to use to defend its fixed exchange rate target. Uncertainty about the reserve level that a policymaker is willing to use to defend the exchange rate was first examined by Krugman (1979), who pointed out the possibility of alternating crises and recoveries of confidence that such uncertainty may entail. ^22/ A general result, however, seems to be that speculative behavior is quite sensistive to the specification of the process which produces the critical level of foreign reserves. Depending on whether the threshold level is stochastic, or fixed but unknown to agents, currency speculation reveals itself as, respectively, a speculative outflow distributed over several periods of time or a sudden speculative attack on the currency (Willman, 1989).

Uncertainty about domestic credit growth was first introduced by Flood and Garber (1984b), in a discrete - time stochastic model. In their framework, credit is assumed to depend on a random component. ^23/ In each period, the probability of collapse in the next period is found by evaluating the probability that domestic credit in the next period will be sufficiently large to result in a discrete depreciation, should a speculative attack occur. In the Flood-Garber framework a fixed rate regime will collapse whenever it is profitable to attack it. The condition for a profitable attack is, as in the model developed above, that the post-collapse exchange rate, s_t be larger than the prevailing fixed rate $\overline{s}$. Profits of speculators are equal to the exchange rate differential times the reserve stock used to defend the fixed rate regime. Since these are risk-free profits, earned at an infinite rate (speculators could always sell foreign exchange back to the central bank at the fixed rate if the attack is unsucessful), the system will be attacked if s_t > $\overline{s}$. Therefore, the probability at time t of an attack at time t+1, denoted t^πt+1 given by

The specific form of the process driving S_t will determine the exact form of t^πt+1. ^24/ From equation (19), the expected rate of depreciation of the exchange rate is given as

where $E_t\left(s_{t+1}\right|s_{t+1}>\overline{s})$ denotes the conditional expectation of s_t+1.

The expected rate of exchange rate depreciation given by (20) will change as the value of the variables forcing s_t change. The expected rate of change of the exchange rate increases prior to the collapse because both t^πt+1 and $E_t\left(s_{t+1}\right|s_{t+1}>\overline{s})$ rise with the approach of the crisis. ^25/ The probability of an attack next period, t^πt+1, rises because the increasing value of the state variable (domestic credit) makes it increasingly likely that an attack will take place at t+1. The quantity $E_t\left(s_{t+1}\right|s_{t+1}>\overline{s})$ gives the value agents expect the exchange rate to be next period, given that there will be a speculative attack at t+1. In turn, that value depends on the value agents expect for the state variable next period, given that an attack will occur at t+1. As the value of the state variable rises from period to period, its conditional expectation also rises as well as the conditional expected rate of change of the exchange rate. As a result, the domestic nominal interest rate rises with the approach of the crisis.

The Flood-Garber stochastic approach has given rise to a number of empirical applications, which are examined below. ^26/ The introduction of uncertainty in collapse models has several implications for the predictions of these models, beyond being consistent with a rising interest-rate differential prior to the crisis. First, the transition to a floating regime is stochastic, rather than certain. The collapse time becomes a random variable and cannot as before be determined explicitly, since the timing of a potential future speculative attack is unknown. Second, there always exists a non-zero probability of a speculative attack in the next period, ^27/ a possibility which, in turn, produces a forward discount on the domestic currency—a phenomenon known as the “peso problem” (Krasker, 1980). The evidence discussed in Section II suggests indeed that the forward premium—or, as an alternative indicator of exchange-rate expectations, the parallel market premium—in foreign exchange markets tends to increase well before the regime collapse. Third, the degree of uncertainty about the central bank’s credit policy plays an important role for the speed at which reserves at the central bank are depleted (Claessens, 1991). In a stochastic setting, reserve losses exceed increases in domestic credit because of a rising probability of regime shift, so that reserve depletion accelerates on the way to the regime change. Thus, uncertainty can help explain the pattern of reserves described in Section II.

3. Asset substitutability and sticky prices

Extensions of the theory of balance-of-payments crises to a world of sticky prices and imperfect asset substitutability have been discussed by Flood and Hodrick (1986), Blackburn (1988) and Willman (1988). ^28/ A simple way to introduce sluggish price adjustment in the basic framework developed above requires dropping the assumption of perfect substitutability between domestic and foreign goods (which yields the purchasing power parity condition (4) and implicitly implies an instantaneously cleared goods market) and specifying a Dornbusch-type price equation of the form ^29/

in which aggregate demand is inversely related to the real exchange rate and the real interest rate. The parameter A measures the speed of adjustment of prices to excess demand. Using equations (1)-(3), (4’) and (5) and setting as before i^* = Ῡ = 0 yields, under floating exchange rates and perfect foresight, a non-homogeneous differential equation system in s_t and p_t :

The two eigenvalues of this system are given by

It is easy to verify that provided that (1 - λΨ) > 0, the system (21) is saddle-point stable, with one negative root (denoted by ρ) and one positive root. ^30/ Solving for the particular solutions yields

where A is an arbitrary constant which can be determined by imposing an initial condition on the predetermined output price. ^31/

The solution value for s_t can be used to determine the timing of the crisis, which occurs, as before, at the point where the shadow exchange rate equals the prevailing fixed rate. Although an explicit solution cannot be derived analytically here, the collapse time can be determined graphically at the intersection of the curve Ae^ρt and the straight line $\overline{s}-\gamma D_0-\gamma \mu (\alpha +1/\lambda \delta )-\gamma \mu t$.^32/ Moreover, it can also be established (by implicit differentiation) that, under fairly general conditions, the higher the degree of price flexibility, the earlier the crisis occurs $(\partial t_c/\partial \lambda <0)$. Essentially, this result derives from the anticipatory movements in prices in the sticky-price regime. Under perfect substitutability between domestic and foreign goods, the output price remains constant (at the prevailing fixed exchange rate) until the crisis occurs, at which point it rises by the amount of exchange rate depreciation. By contrast, when the speed of adjustment to aggregate excess demand is less than infinite, a perfectly anticipated future collapse of the exchange - rate regime has an immediate effect on the behavior of domestic prices. Specifically, prices begin rising gradually (as soon as agents become aware that the exchange rate is not viable indefinitely) so as to prevent any jump when the regime switch occurs. The higher the degree of price inertia, the longer it will take for prices to adjust and ensure a “smooth” transition—and therefore the longer will be the time elapsed before the collapse. ^33/

The effect of price flexibility on the collapse time derived above has also been highlighted by Blackburn (1988). In addition, Blackburn also examines the role of imperfect asset substitutability in the collapse process. His analysis shows that the higher the degree of capital mobility, the earlier the crisis occurs. As in Willman’s (1988) model, imperfect substitutability between domestic and foreign bonds implies that it is essentially the accumulating trade balance deficit which leads to depletion of foreign reserves and eventually causes the balance - of - payments crisis. Because of the potential impact of government spending on external deficits, it is therefore not just monetary policy, but rather the fiscal-monetary mix which is of importance in the analysis of the collapse process.

4. Output, the real exchange rate and the current account

The early literature on balance-of-payments crises focused on the financial aspects of such crises and ignored the real events occuring simultaneously. The evidence examined in Section II suggests, however, that balance-of-payments crises are often associated with large trade balance and current account movements during the periods preceding, as well as during the periods following, such crises. Typically, large current account deficits tend to emerge, as agents adjust their consumption behavior (and not only the composition of their holdings of financial assets) in anticipation of a crisis. The evidence regarding the experiences of Argentina and Mexico reviewed above shows how important the movements in the real exchange rate and the current account have been in these countries in the periods preceding exchange-rate crises. Such movements may provide an additional argument to explain why (in addition to uncertainty, discussed above) runs on reserves rarely occur abruptly but are generally preceded by a period during which official foreign reserves are lost at increasing rates. ^34/

The real effects of a potential exchange rate crisis have been investigated by Flood and Hodrick (1986) in economies with sticky prices and contractually predetermined wages, and by Willman (1988) in the context of a simple model with endogenous output and foreign trade. ^35/ Following Willman, we can assume that—as in equation (4’)—domestic output is demand-determined, positively related to the real exchange rate, and inversely related to the real interest rate. The trade balance depends also positively on the real exchange rate, but is negatively related to domestic output. A crucial feature of Willman’s model is the existence of forward-looking wage contracts, as in Calvo (1983). Under perfect foresight, an anticipated future collapse will affect wages, which, in turn, will influence prices, the real exchange rate and therefore output and the trade balance. The behavior of these variables is represented in Figure 8.^36/ At the moment the collapse occurs, the real interest rate falls because of the jump in the rate of depreciation of the exchange rate. Output therefore increases, while the trade balance deteriorates. If nominal wages were fixed or backward-looking, output would be “flat” before the collapse occurs, since there are no anticipatory movements. But since wage contracts are forward-looking, anticipated future increases in prices are discounted back to the present and affect current wages. As a result, prices start adjusting before the collapse occurs. The real interest rate falls gradually, and experiences a downward jump at the collapse time, resulting from the upward jump in the rate of inflation. The decline in the (ex post) real interest has an expansionary effect on domestic activity before the collapse. However, output also depends on the real exchange rate. The steady rise in domestic prices is associated with an appreciation of the domestic currency and a negative impact on economic activity which may outweigh the positive output effect resulting from a lower real interest rate. In Figure 8, the net impact of an anticipated collapse on output is shown to be negative—a likely outcome if relative price effects are strong. The continuous loss of competitiveness, unless it is associated with a fall in output, implies that the trade balance deteriorates in the pre-collapse fixed exchange rate regime. The trade deficit increases further at the moment the crisis occurs, and returns gradually afterwards to its steady-state level.

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Output, Real Interest Rates, the Real Exchange Rate and the Trade Balance

Citation: IMF Working Papers 1991, 099; 10.5089/9781451852189.001.A001

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In the model described above, the real exchange rate appreciates until the collapse time, at which point it starts depreciating smoothly. This feature of the model seems to account fairly well for the steady real appreciation and subsequent depreciation observed during crisis episodes in countries such as Argentina in 1980-81. By contrast, in the models developed by Calvo (1987) and Connolly and Taylor (1984), the real exchange rate experiments a downward jump at the time of the crisis—a feature of the collapse process which appears difficult to rationalize in a perfect foresight world. In Connolly and Taylor’s model for instance, the price of traded goods is fixed at the time of a speculative attack. It cannot jump because the exchange rate is continuous (as a result of the asset-price continuity assumption) and the world price of traded goods is assumed constant. Consequently, a sharp real depreciation at the time of the crisis must be attributed, under perfect foresight, to a substantial fall in the nominal price of nontraded goods—an assumption which implies an implausible degree of downward price flexibility for most economies.

5. Borrowing, controls, and the postponment of a crisis

A common feature in countries experiencing balance-of-payments difficulties has often been recourse to external borrowing to supplement the available amount of reserves, or the imposition of restrictions on capital outflows to limit losses of foreign exchange reserves. In the basic model developed above, it has been assumed that there is a critical level, known by everyone, below which foreign reserves are not allowed to be depleted. In practice, however, it is doubtful whether any such binding threshold exists. A central bank facing a perfect capital market can—at least in principle—create foreign reserves by borrowing. Thus negative (net) reserves are also feasible. ^37/

Pressing the argument a little further suggests that perfect access to international capital markets implies that, at any given point in time, central bank reserves can become (infinitely) negative without violating the government’s intertemporal budget constraint. Such access to unlimited borrowing could, in principle, indefinitely avoid a regime collapse. The rate of growth of domestic credit cannot, however, be indefinitely maintained above the world interest rate, because it would lead to a violation of the budget constraint (Obstfeld, 1986a). In this sense, an over-expansionary credit policy still leads to the collapse of a fixed exchange - rate regime. A similar point has been emphasized by van Wijnbergen (1988, 1991). ^38/

Moreover, even with perfect capital markets, the timing of borrowing matters considerably for the nature of speculative attacks. Suppose that the interest cost of servicing foreign debt exceeds the interest rate paid on reserves. If borrowing occurs just before the exchange rate regime would have collapsed absent borrowing, the crisis is likely to be postponed. If borrowing occurs long enough before the exchange rate regime would have collapsed in the absence of borrowing, the crisis would occur earlier. The reason why the collapse is brought forward is, of course, related to the servicing cost of foreign indebtedness on the fiscal deficit, which raises the rate of growth of domestic credit (Buiter, 1987).

In practice, most countries face borrowing constraints on international capital markets. The existence of such constraints has important implications for the behavior of inflation in an economy where the government—like private agents—is subject to an inter-temporal budget constraint. Consider, for instance, a country which has no access to external borrowing and in which the central bank transfers to the government its net profits. If a speculative attack occurs, the central bank will lose its reserves and its post-collapse profits from interest earnings on foreign assets will drop to zero. As a consequence, net income of the government falls and the budget deficit deteriorates. If the deficit is financed by increased domestic credit (a typical situation if access to external borrowing is limited) the post-collapse inflation rate will exceed the rate that prevailed in the pre-collapse fixed exchange - rate regime, raising inflation tax revenue so as to compensate for the fall in interest income (van Wijnbergen, 1988, 1991).

Another policy measure aimed at postponing a regime collapse which has been used to limit losses of foreign exchange reserves relates to capital controls. Restrictions of this type have been imposed either permanently or temporarily after significant losses. ^39/ A simple way to introduce permanent controls in the above setting is to re-write equation (5) as

This equation states that deviations from the domestic interest rate from uncovered interest parity are accounted for by the existence of capital controls, which are modelled here as a proportional tax on foreign interest earnings. ^40/ Using (5’) and solving the model as before, the collapse time is now given by

Equation (13’) indicates that the higher the degree of capital controls (the higher ρ), the longer it will take for the regime shift to occur.

The impact of temporary capital controls on the timing of a balance-of-payments crisis has been studied by Bacchetta (1990), Delias and Stockman (1988), and Wyplosz (1986). In Wyplosz’s model the domestic country expands credit excessively. Capital controls are in force, and residents are not allowed to hold foreign currency assets (or to lend to non-residents), but non-residents are free from restrictions. There are only two assets, domestic money and foreign money. Non-residents monitor reserve levels, provoking a “crisis” when reserve levels equal non-resident holdings of domestic currency. The currency is then devalued, setting off a new cycle. The analysis shows that in the absence of capital controls, a fixed rate regime would be viable only if the monetary authorities maintain a sufficient degree of uncertainty so as to force risk-averse speculators to commit only limited amounts of funds in anticipation of a crisis. ^41/

It has been argued, however, that even with perfect foresight the regime might still be viable if interest rates are endogenous—a feature which is absent in Wyplosz’s model (Giavazzi and Pagano, 1990). Interest rates have an equilibrating role that eliminates the incentive for a run on reserves. For instance, if the public anticipates a devaluation, it will shift out of domestic money. The authorities accomodate the public, say, by bond sales at interest rates that reflect these expectations; such bond sales avert the need to shift into foreign assets. The implication of the analysis, however, is that without capital controls interest rates are likely to display substantial variability. ^42/

Restrictions on foreign transactions also have real effects, as shown by Bacchetta (1990) who examines the effect of anticipated temporary capital controls in the process of a balance of payments crisis. The anticipation of controls affects the behavior of agents as soon as they are announced—or as soon as agents realize the inconsistency between the fiscal policy and the fixed exchange rate—and usually translate into a current account deficit, as capital out- flows are substituted by increased imports. A speculative attack may, however, occur just before the controls are imposed. Such an attack may therefore well defeat the very purpose of capital controls. ^43/

6. Policy switches and the avoidance of a collapse

Early models of balance-of-payments crises have beeen generally limited to the consideration of an “excessive” rate of credit creation. ^44/ The apparently inevitable character of a regime collapse that such an assumption entails runs into a conceptual difficulty, namely, why is it that the authorities do not attempt to prevent the crisis by adjusting their fiscal and credit policies? ^45/ Moreover, there is nothing in the model which requires the central bank to float the currency and abandon the prevailing fixed exchange rate at the moment reserves hit their critical lower bound; instead, the monetary authority could as well change change its monetary policy rule to make it consistent with the fixed exchange rate target. Some recent models of balance-of-payments crises have considered this type of endogenous changes in monetary policy. For instance, in Drazen and Helpman (1988) the assumption that the authorities choose to adjust the exchange rate instead of altering underlying macroeconomic policy that is inconsistent with the existing exchange parity, can only provide a temporary solution. But ultimately, if the new exchange rate regime is inconsistent with the underlying fiscal policy process, there will be a need for a new policy regime. A similar argument has been made in the context of developing countries (Edwards and Montiel, 1989).

In the context of a model of the Gold Standard, Flood and Garber (1984b) showed that an attack on a price-fixing scheme can be self-fulfilling. This self-fulfilling aspect was applied to exchange-rate fixing by Obstfeld (1986b). A collapse, in these models, results from an indeterminacy of equilibrium that may arise when agents expect a speculative attack to cause an abrupt change in government macroeconomic policies. Suppose, for instance, that a country fixes its exchange rate and maintains a stable credit policy in “normal times”. In the event a speculative attack occurs, however, the country will cease fixing the exchange rate and will increase the rate of growth of domestic credit. Evidently the private sector can be in equilibrium with either policy. If an attack never occurs, the fixed exchange rate will survive indefinitely. If there is an attack the system may collapse. The indeterminacy arises because the authorities’ credit policy is not exogenous to the collapse.

Uncertainty about the post-collapse credit rule can also cause a fixed exchange-rate regime to collapse—just as arbitrary speculative behavior (or noneconomic extrinsic factors which private agents may believe to trigger a crisis) would. Formally, a simple way to introduce policy uncertainty in the basic model developed above is to allow two possibilities with respect to the credit policy rule (Willman, 1987): there is a probability q that the monetary authority will maintain the existing rule given by (3) and float the currency from the moment the stock of foreign exchange reserves has been depleted to zero, and a probability (1 - q) that the authorities will adopt a zero-growth rule consistent with the fixed rate regime, that is

Using (3’) and solving as before, the collapse time can be shown to be now equal to

The earlier result (equation 13) corresponds to a probability equal to one. If the probability is zero, a speculative attack never occurs and the system collapses “naturally”. The smaller q—the greater the probability that the monetary authorities alter the credit policy rule (3)—the longer it takes before the collapse occurs.

An alternative way to formalize the effect of a possible future policy switch is as follows. Suppose that the process driving domestic credit is given by (3’) instead of (3),

where dz_t is a standard Wiener process, and a is a constant. ^46/ To derive the solution for the flexible exchange rate in the post-collapse regime, set R_t = 0 in (2) and use (4), (5) in (1) to get

Suppose that speculators expect the central bank to alter its credit rule (3’) in the future—even while allowing the exchange rate to float initially. ^47/ More precisely, the central bank may decide to again fix the exchange rate, if a higher limit on domestic credit $\overline{D}$ is reached, ^48/ Such anticipated behavior will affect the behavior of the floating exchange rate. The shadow rate is now given by ^49/

where $\tilde{\lambda }$ is the positive root of the quadratic equation in λ,

The collapse date t_c is now a stochastic variable which can be determined by using the “first-passage” probability density function, given for instance in Feller (1966, pp. 174-75).

1. Speculative attacks on a target zone

The literature on fixed exchange rates has usually modeled the policy of fixing the exchange rate by having the policy authority adopt a particular number for the exchange rate and by standing willing to buy or sell foreign exchange to maintain this price. In actual practice, such as in the Bretton Woods system or the Exchange Rate Mechanism (ERM) in the European Monetary System, the exchange rate commitment involves announcing a range for the exchange rate and intervening to preserve this range. Such a policy has been termed a target zone for the exchange rate and a large literature has grown recently studying the behavior of the exchange rate in a target zone regime.

One of the important insights of the target zone literature has been that a credible target zone would stabilize exchange rate movements within the zone. This was Krugman’s (1990) “honeymoon effect”. More recently Krugman and Rotemberg (1990) studied target zones that were less than perfectly credible because the reserves committed to defense of the zone were limited. In the Krugman-Rotemberg scenario an exchange rate target zone might collapse exactly as the theoretical fixed rate regime collapses in a final speculative attack and a return to a flexible exchange rate.

In their example, Krugman and Rotemberg show that limited reserves and the possibility of a speculative attack weaken the “honeymoon” effect. With a speculative attack a possibility, agents are not certain of an effective forthcoming intervention to preserve the zone. Therefore agents’ expectations are less dogmatic than in a zone of certain permanence. In a permanent zone, agents always expect the exchange rate to be moved back toward the center of the zone when the rate drifts toward the edges. Such rationally regressive expectations are responsible for the “honeymoon” effect—a shock, which in the absence of the credible zone would move the exchange rate (say) up by 10 percent has a smaller effect on the exchange rate in a credible zone because the shock sets into motion the expectation of the return of the exchange rate toward its initial level. Once the zone is not perfectly credible however, the expected return of the exchange rate is dampened and so the “honeymoon” effect is less powerful.

2. The “Gold Standard Paradox”

Suppose that a small country is operating under a fixed exchange rate and that the country’s demand for money is rising secularly faster than the domestic credit component of its money supply. The country can expect to gain international reserves over time and it might expect its fixed rate to be indefinitely viable. But suppose also that the country experiences a temporary downward disturbance in money demand which is large enough to exhaust its stock of reserves. In the long run, the country’s fixed rate is still viable but in the short run, since reserves are exhausted, the country may have to abandon the fixed rate regime. When the country switches to a flexible exchange rate, the long-term expected increase in the excess demand for money implies that the currency will be stronger in the forward market than in the spot market, or that domestic interest rates will fall below world interest rates. The reduction in domestic interest rates following the abandonment of the parity will therefore increase money demand and appreciate the domestic currency as compared with the fixed rate. The “Gold Standard Paradox” refers to a situation where the fixed rate system would collapse and that following the collapse the domestic currency would become more valuable.

Two “resolutions” to this paradox have been offered in the literature. The first is the Buiter-Grilli (1989) solution, which works only in a zero-interest environment. The second type of solution is the Salant (1983) price-fixing rule as applied by Krugman and Rotemberg (1990). This “solution” consists in a change in the rules of the game, that is, the implementation of a rule which sets a floor on the domestic currency price of reserves and ensures the impossibility of a speculative attack when the price of reserves falls at the instant of an attack. However, analytical solutions have so far been obtained only in cases where fundamentals follow some simple stochastic processes.

3. Reputation as a deterrent to speculative attacks

In line with recent developments in the macroeconomic policy game literature, another potentially fruitful line of enquiry could be to examine the effect of exchange rate credibility on balance-of-payments crises. ^54/ A fixed exchange rate regime will, in general, never carry full credibility. Official pronouncements notwithstanding, there is always a risk that when official reserves are being run down, a country will opt to alter its exchange rate rather than its monetary and/or fiscal policy. When agents perceive that the authorities’ commitment—and ability—to maintain a fixed exchange rate is weak, speculative attacks may occur. Such attacks may occur when the competitiveness of a high-inflation country has been eroded by adhering to the nominal exchange rate parity. This will typically reduce the degree of confidence in the existing exchange rate and will raise expectations that the currency will be devalued. A speculative attack can therefore be self-fulfilling because it may lead to an eventual exhaustion of the authorities’ foreign exchange reserves, leaving the authorities with little choice but to devalue (see Wood, 1991). Such a situation may be exacerbated if price setters incorporate the possibility of a devaluation in their pricing procedures, thereby adding further inflationary pressure. An important issue, in this context, is the extent to which reputational factors (such as the appointment of a “conservative” central banker for instance, as suggested by Rogoff, 1985) may mitigate the credibility problem and ensure the viability of a fixed-rate regime.

4. Econometric testing of collapse models

As discussed in the previous section, most empirical studies on balance-of-payments crises have been conducted in a developing-country context. The existing literature has, however, typically ignored the critical role often played in these countries by the parallel market for foreign exchange in diffusing speculative pressures on the official parity—a mechanism which has been formally examined by Agénor (1990) and Agénor and Delbecque (1991). ^55/ If foreign exchange is rationed in the official market, an expansionary credit policy will depreciate the parallel exchange rate. The resulting increase in the premium will raise prices, appreciate the real exchange rate, and encourage diversion of export proceeds from the official to the parallel market—consequently accelerating the rate of reserve losses and precipitating the collapse of the official exchange rate. A devaluation entails a fall in the premium in the short-run, ^56/ but the parallel rate will continue to depreciate if credit policy remains expansionary. As in the standard model of balance-of-payments crises, a fixed-exchange rate system is viable only if the authorities are able to maintain fiscal and monetary discipline. This analysis suggests that future empirical research on balance - of-payments crises in developing countries should aim at explaining simultaneously the behavior of the parallel market premium and foreign exchange reserves.