Exchange Rate Economics: Theories and Evidence

Speculative attack models and contagion 319
A number of papers relax the assumption of perfect foresight used in the earlier
variant of the first generation model by assuming the domestic credit expansion
is stochastic (see, inter alia,Flood and Garber 1984; Obstfeld 1986; Dornbusch
1987). This means that the date of the attack becomes uncertain and in the
run-up to the attack the domestic interest rate will exhibit a peso effect (see
Chapter 15).
In sum,first generation models emphasise the link between fundamentals and a
currency crises in a linear framework. Although they have been regarded as wellsuited
to explaining certain Latin American crises in the 1970s and 1980s they
are not deemed to be very useful in understanding currency crises in the 1990s.
For example,at the time of the breakup of the ERM in 1992–3 and the Asian
meltdown of 1997–8 countries seemed to have sufficient international reserves and
sound monetary–fiscal mixes. As we noted in the introduction,the value added
of second generation models is that they can explain speculative attacks against a
currency even when the underlying fundamentals of that currency appear healthy.
In particular,these models make agents’ expectations endogenous and introduce
important non-linearities.
13.1.3 The base-line second generation model
The paper that started the second generation literature is that of Obstfeld (1986)
and his modification to the basic model involves assuming that the second-period
monetary policy depends on the government’s decision on whether or not to
devalue in the first period. This therefore introduces a policy non-linearity into
the model and can be illustrated in the following way.
If there is no attack on the currency,domestic credit grows at a rate µ 0 and has
a shadow exchange rate associated with it of ŝ µ0 . Alternatively,if there is an attack
and the currency is devalued domestic credit grows at a rate µ 1 ,where µ 1
>µ 0
,and
the corresponding shadow exchange rate is ŝ µ1 . Obstfeld argues that the higher
monetary growth in the post-attack scenario could arise if the government is cut-off
from borrowing overseas after the attack and has to engage in extra monetisation
of its debt. The two scenarios are illustrated in Figure 13.3,where for illustrative
purposes we assume µ 0 = 0 so that the fixed rate would survive indefinately for
some given d.
Suppose d is to the left of d B . If there is no attack then the shadow rate will
be on the ŝ µ0 schedule while if there is an attack the shadow rate jumps to the
ŝ µ1 line which is still below the fixed exchange rate and therefore implies a capital
loss for speculators. Therefore in this scenario there will be no incentive to attack
and the fixed rate is compatible with domestic credit and survives indefinitely.
Suppose now that domestic credit is at a level d B . With µ = µ 0 we now have an
intersection at C. If speculators attack the rate jumps from C to B and the attack
will be successful. However,notice that there is no profit for speculators since there
is no immediate capital gain from any reserves purchased from the central bank.
So in equilibrium the system could equally be at B or C since there is no incentive
to move to point B.