Exchange Rate Economics: Theories and Evidence

332 Speculative attack models and contagion
of devaluation than the purely fundamentals-based model because it is capturing
sunspot activity.
Jeanne (1997) estimates a variant of (13.42) using maximum likelihood methods
for the French franc ERM crises,using monthly data from 1991 to 1993. He finds
that the jumps in expectations that occurred in September 1992,the first quarter
of 1993 and July 1993 are not well explained by the fundamentals alone but are
well explained when a regime switch is allowed for. This is interpreted as prima
facie evidence that the crises are better interpreted as self-fulfilling. Martinez-Peria
(1997) has applied the Markov–Switching methodology,with some success,to a
broader range of EMS currencies. Cerra and Saxena (2000) has applied it to the
1997 crises of the Indian rupiah.
However,there have been a number of criticisms levelled against the kind of
empirical evidence presented in this section. First,favourable results,such as those
generated by Jeanne and Masson from a Markov–Switching model,could simply
reflect some form of omitted variable bias. For example,the reduced form of
Jeanne and Masson does not contain a variable which first generation models indicate
as important,namely,foreign exchange reserves. Second,the reduced-form
nature of the model makes it possible to interpret the results in a different way,
perhaps due to rational learning. For example,Krugman considers an economy
with a steadily rising unemployment rate in which market participants believe the
government will devalue when the unemployment rate reaches between 12% and
14%. This means that devaluation expectations will jump up when unemployment
reaches 12% and fall back when it exceeds 14%. Such behaviour would be
observationally equivalent to a self-fulfilling jump in expectations,but it is simply
a reflection of rational learning process. Alternatively,such results could reflect
informational asymmetries. For example,in the model of Caplin and Leahy (1994),
much as in the market microstructural models of Chapter 14,agents receive private
information and do not immediately reveal this to the rest of the market because
they have to pay a fixed cost to reallocate their portfolios. When some threshold
is reached investors withdraw from a market en mass and the information gets
aggregated,thereby precipitating the crash. The informational cascade models
of Banerjee (1992); Bikhchandani et al. (1992) and Chari and Kehoe (2003) also
rely on the dispersal of private information amongst investors. In these models
investors receive information sequentially and each investor observes the prior
decisions of the last investor in the chain. In these models if the signals are noisy
it may be optimal for the investor to ignore her private information and simply
imitate the decision made by previous investors. Such repeated imitation could
lead to an outcome very similar to that uncovered by the Markov–Switching
models. The main problem with models which rely on private information is
that most information of relevance to foreign exchange markets is public and of
that which is not – such as the order flow – will be disseminated pretty rapidly
if it is of sufficient import to result in the collapse of a currency. As we have
noted earlier,speculative attack models have also been criticised from a theoretical
perspective.