Arbitrage mechanism leading to currency crises: a theoretical perspective

Lilia Cavallari and Giancarlo Corsetti

No 28, Working Papers in Public Economics from Department of Economics and Law, Sapienza University of Roma

Abstract: In his seminal contribution on exchange rate crises, Krugman models speculative attacks as optimal market reactions to policy rules that are inconsistent with the indefinite survival of a fixed nominal parity. Later contributions have shifted the focus of the analysis, modelling exchange rate crises as rational decisions by optimizing policy makers to abandon the peg. This paper analyzes the logical core of the two modelling strategies in terms of arbitrage. We use a generalized version of the arbitrage rule first discussed by Flood and Garber, that expresses the conditions for a crisis to occur in the metric of the shadow exchange rate. Our arbitrage-based methodology of analysis can be applied to virtually all models of exchange rate crises.

Keywords: Balance of payment crises; Speculative attack; Devaluation; Fixed exchange rate; multiple equilibria. (search for similar items in EconPapers)
JEL-codes: E58 F33 (search for similar items in EconPapers)
Pages: 22
Date: 1997-07
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