Coordination and Policy Traps

George-Marios Angeletos (), Christian Hellwig and Alessandro Pavan

No 9767, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper examines the ability of a policy maker to control equilibrium outcomes in an environment where market participants play a coordination game with information heterogeneity. We consider defense policies against speculative currency attacks in a model where speculators observe the fundamentals with idiosyncratic noise. The policy maker is willing to take a costly policy action only for moderate fundamentals. Market participants can use this information to coordinate on di.erent responses to the same policy action, thus resulting in policy traps, where the devaluation outcome and the shape of the optimal policy are dictated by self-fulfilling market expectations. Despite equilibrium multiplicity, robust policy predictions can be made. The probability of devaluation is monotonic in the fundamentals, the policy maker adopts a costly defense measure only for a small region of moderate fundamentals, and this region shrinks as the information in the market becomes precise.

JEL-codes: C72 D82 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ifn
Date: 2003-06
Note: EFG IFM
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