Exchange Rate Economics: Theories and Evidence

320 Speculative attack models and contagion
s
s
sm1 > 0
s m0 = 0
B
s
C
A
d B d d
Figure 13.3 Second generation speculative attack model.
If domestic credit is in the range d A to d B and speculators were subsumed into
a representative agent then an attack would be successful in this range since the
economy would move to the new shadow line,there would be a run on the currency
and the currency would depreciate. Here the authorities validate the attack ex post
by engaging in the higher monetary creation,and this gives an outcome which is
observationally equivalent to the kind of attack considered in the first generation
model. Here though the crucial difference is that the outcome is being driven by
the exogenous ‘sunspot’ expectations of the representative speculator.
In reality,however,speculators are a group who often have heterogenous
beliefs and the coordination of their expectations on the sunpsot variable may
not be straightforward. For example,if speculators are individually small and
uncoordinated then they will have little market power to individually change the
rate and multiple equilibria may still arise. For example,a speculator who believes
the currency is overvalued will not attack the currency unless he believes there is a
chance the rest of the market has the same expectation and will actually follow suit.
In this case the economy could stay indefinitely on the lower shadow line. Alternatively,if
all speculators believe the currency should be attacked the attack will,
as in the case of the representative agent outcome,force the currency to devalue.
In a heterogenous market one way this could occur is if there is one large player –
for example,a Soros type figure – who leads the market to its new equilibrium
(the coordination issue is discussed later).
Jeanne (2000a) provides a nice critique of the first and second generation speculative
attack models. In particular,what is to stop the central bank engaging in
unsterilised changes in domestic credit to keep the interest rate at a level which offsets
the devaluation expectations and sustains reserves above the minimum level?