Self-Fulfilling Risk Predictions: An Application to Speculative Attacks

Robert Flood and Nancy Marion

No 1998/124, IMF Working Papers from International Monetary Fund

Abstract: The paper shows that changing market beliefs about currency risk can generate a self-fulfilling speculative attack on a fixed exchange rate. The attack does not require a later change in policies to make it profitable. This is illustrated by introducing an endogenous risk premium into a “first-generation model” of a speculative attack. The model is further modified to take account of sterilization, debt-financed fiscal deficits, and anticipatory price-setting behavior. The model is used to interpret the 1994 Mexican peso crisis.

Keywords: WP; shadow exchange rate; money demand; U.S. dollar; Currency crisis; devaluation; risk premium; Mexico; exchange-rate variance; exchange rate float; market structure; price level; shadow rate; Conventional peg; Exchange rates; Return on investment; International reserves; Monetary base; Europe; Asia and Pacific (search for similar items in EconPapers)
Pages: 34
Date: 1998-08-01
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Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:imf:imfwpa:1998/124

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