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When interest equals time preference, as it does continuously in the small-open-economy model, current and present-value consumption move in the same direction. The agent does not want to increase current consumption in the absence of an increase in present-value consumption.
For simplicity, the government is assumed to issue no government debt to private agents. However, in a world in which private bonds and government debt are perfect substitutes, all results would be identical.
This policy, together with a floor on reserves, assures solvency for the government:
The consequences of relaxing this assumption are considered at the end of the paper.
Obstfeld (1986, 1994) discusses the possibility of a self-fulfilling crisis, conditional on a change in policy with collapse. Others have also suggested the possibility of multiple equilibria to explain instances of collapse which take the markets by surprise.
With a speculative attack agents lose
It is possible, when utility is not logarithmic, for the increased wealth to create an equal increase in present-value expenditures on money and no increase in desired consumption. This yields different results. See Daniel (1997).
Note that increased current consumption and an implied current account deficit cannot be an optimal path. With current consumption up, and present-value consumption unchanged due to the resource constraint, then future consumption would have to fall. With interest equal to time preference, the agent has no reason to plan for a decrease in future consumption.
For the policy exercise in the previous section, the policy variable is the level of transfers, implying that the present value of transfers increased irrespective of the initial level of reserves.
It is interesting to note that the policy in this section replicates the essentials of policy in Flood and Garber (1984), where the scale variable is constant and where policy is control of the rate of domestic credit creation. Satisfaction of the fiscal constraint assures that the scale variable is constant, conditional on collapse at time T.
In a two-country model, policy change must leave the present value of seigniorage revenues, relative to the agent’s non-monetary wealth (bonds plus present-value disposable income), unchanged. See Daniel (1997).