Optimal Exchange Rate Regimes: Sunspots, Currency Crises, and Welfare

Carsten Nielsen

Rivista Internazionale di Scienze Sociali, 2004, vol. 112, issue 2, 155-194

Abstract: In this two country OLG model there is a potential role for active governments since markets are incomplete. There are many coordinated policies (exchange rate regimes) that result in an optimal allocation if extrinsic uncertainty plays no role. However, if we take into account the possibility of sunspot equilibria, the set of optimal policies is drastically reduced. Whenever there is a possibility of influence by extrinsic uncertainty, one or both governments may seek to avoid this by intervening on the foreign exchange markets. When only one country does so, this may lead to a currency crisis, where the central bank is active and is with positive probability unsuccessful in its attempt to defend its currency. If the two countries form a monetary union, a coordinated fiscal policy is needed as a substitute for an optimal exchange rate regime.

Keywords: currency crisis; exchange rate policies; monetary union; OLG model; perfect currency (search for similar items in EconPapers)
JEL-codes: D42 D60 D84 F31 F42 (search for similar items in EconPapers)
Date: 2004
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