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Rational Speculation, Financial Crises, and Optimal Policy Responses
Author:
Jay Surtinull

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Series:
IMF Working Papers
Volume/Issue:
Volume 2004: Issue 025
Language:
English
Publication Date:
01 Feb 2004
DOI:
https://doi.org/10.5089/9781451844290.001
ISBN:
9781451844290
ISSN:
1018-5941
Pages:
28
Keywords:
WP; financial market; equilibrium market dynamics; liquidity constraint; market expectation
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IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
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This paper develops a theory of the onset of financial crises by solving for the optimal trading strategies of speculators in financial markets, in a model where each speculator tries to coordinate her trades with the market's by observing the decisions of other speculators, while simultaneously trying to preempt the market. The interaction and resolution of these two conflicting incentives are analyzed under alternate central bank policy regimes. Our model explains how imperfect information structures prevent traders from exploiting profitable opportunities and suggests how large traders help alleviate this problem by undertaking risky arbitrage early in the investment process, in return for higher profits, if successful. The central bank's defense strategy is a parameter of this model. We compare the likelihood of a crisis under alternate defense strategies and show that credible monetary authorities can provide a better defense of exchange rate regimes against adverse shocks by not disclosing their commitment value to the market.
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Cover IMF Working Papers
IMF Working Papers
ISSN:
1018-5941
Publisher:
International Monetary Fund
Volume 2004: Issue 025