Exchange Rate Economics: Theories and Evidence

Speculative attack models and contagion 321
The speculative attack models therefore dodge the issue of why monetary
authorities who have the power in the run-up to an attack,or at the time of an
attack,to raise interest rate do not always do so. By failing to answer this question
Jeanne (2000a) argues that the speculative attack model misses an important link
in the logic of currency crises. Of course,raising interest rates in this way is costly
and it is a comparison of the costs and benefits of raising interest rates which will
influence the policy-maker in deciding to maintain a fixed peg. However,in order
to address this kind of issue in the context of a speculative attack model,the policymaker’s
objective function has to be explicitly modelled (i.e. the policy-maker’s
actions have to be endogenised). The so-called escape clause model of Obstfeld
(1994) attempts to do this.
13.1.4 The escape clause variant of the second
generation model
In this section we consider a variant of the escape clause model due to Jeanne
(2000a). Such models have also been included in under the rubric of second generation
models,although it is important to recognise that the escape clause approach
is broader than the second generation model considered in the previous section
since it incorporates a wider range of fundamentals and also it addresses the relationship
between fundamentals and multiple equilibria. The label ‘escape clause’
refers to the fact that in this class of model the authorities may escape from the
fixed peg if it is placing too high a cost on an important variable in the authorities’
objective function,say,the level of unemployment. We now consider this variant
of the second generation model,due to Jeanne (2000a),in a little more detail. As
in our previous discussion,the essence of this model can be captured by thinking
in terms of two periods – prior- and post-attack devaluation. Here the government
decides whether to devalue or not depending on the level of unemployment. The
latter is determined by a standard expectations-augmented Phillips curve:
U 2 = ρU 1 − α(π − π e ),(13.16)
where U 1 and U 2 are deviations of unemployment from the natural level in
periods 1 and 2,respectively,and π is inflation. The decision to devalue in period 2
is obtained by minimising the loss function:
L = (U 2 ) 2 + δC,(13.17)
where δ is a zero/one dummy variable indicating the policy-maker’s decision (=1
if devaluation,0 if not) and C is the cost of abandoning the fixed exchange rate.
The latter is seen to be a function of, inter alia,the effects of increased exchange
rate volatility on trade and investment,and the potential loss of anti-inflationary
credibility by abandoning the peg and potential retaliatory ‘beggar-thy-neighbour’
policies. Using (13.16) in (13.17) we see that if there is no expectation of a
devaluation by the private sector (π e = 0) the government’s loss function is
L D = (ρU 1 − αd) 2 + C if it devalues,and L F = (ρU 1 ) 2 if it does not,