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)| false Dekle, R., C. Hsiao, and S. Wang, 2001, “ Interest Rate Stabilization of Exchange Rates and Contagion in the Asian Crisis Countries” in Financial Crises in Emerging Markets, ed.by ( Reuven Glick, Ramón Moreno, and Mark Spiegel United Kingdom: Cambridge University Press), pp. 347– 79.
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I want to thank Marco Bassetto, V. V. Chari, Larry Jones, and Patrick Kehoe for their advice and guidance. I have also benefited from conversations with Sami Alpanda, Adam Copeland, Antonio Doblas, Thor Koeppl, Meg Ledyard, Ross Levine, Adrián Peralta, Michele Tertilt, and seminar participants at Banco de España, Federal Reserve Banks of Kansas City, Minneapolis, and San Francisco, and Universidade NOVA de Lisboa. I am also grateful to La Caixa for financial support. All remaining errors are mine.
In this respect, my analysis is reminiscent of Obstfeld’s (1986) seminal contribution. This author showed that currency crises may occur even when there is no current inconsistency in the policies of the government, provided that monetary policy is expected to be looser after the peg is abandoned.
There is a growing empirical literature that assesses the effectiveness of tightening monetary policy in order to strengthen a currency. See, for instance, Dekle, Hsiao, and Wang (1999), Eichengreen and Rose (2001), International Monetary Fund (1998), Kraay (2003), and Zettelmeyer (2000).
The conventional wisdom holds that pegs provide more fiscal discipline than flexible regimes. For example, “fixed rates are seen as providing discipline to enable a government to resist the temptation to follow inflationary policies.” Drazen (2000b); or “by acting as a constraint on macroeconomic policies, a fixed exchange rate may enhance the credibility of the central bank’s commitment to maintaining a low and stable rate of money growth.” Agénor and Montiel (1996). Atkeson and Kehoe (2001) discuss the circumstances in which a country will use a fixed exchange rate as a commitment device for not printing money. Giavazzi and Pagano (1988) show how inflation-prone countries can benefit from fixing their exchange rates.
Strictly speaking the central bank’s allocation rule for reserves is as follows. Let
This assumption is not unwarranted. Eichengreen and Rose (2001) present compelling evidence that countries that abandon their peg after a currency crisis experience an increase in the rate of growth of Ml, whereas countries that successfully defended the peg kept Ml at a lower and constant growth rate.
This can be thought of as a tax rebate.
I restrict the maximum level of reserves to be M* [1 – βx*]/(2 – βx). Levels of reserves above this threshold imply negative bond prices.
These payoffs have been obtained for the arbitrary set of parameters: β = 0.95, η = 2, α = 0.7, y* = 1, M* = 1, x* = 0.1, and
This payoff is decreasing in R0 because larger sales of reserves appreciate the domestic currency, i.e. lower s(r, 2).
A good case in point is China which, in the midst of the East Asian crisis, boasted that its level of foreign reserves was over US$ 140 billions.
Recall that s(r, t) = γ(r)s(r, t – 1), where γ(r) is the domestic growth factor.
Notice that if domestic agents were the only ones to purchase domestic bonds, then Ricardian equivalence would hold and the redistributive effects from this policy would be nil.
First-period consumption is decreasing in x because the size of the tax during the first period is an increasing function of x.
For this version of the model it is necessary that the sunspot is realized once the family has split. Otherwise, the segmentation constraint would not have any effect, for agents would adjust their currency holdings as desired before splitting
With no further frictions, capital is free to move until rates of return are equal, all else constant
Note that in the analysis I have not allowed the government to default on its debt.