DP361 | The `Gold Standard Paradox' and Its Resolution

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This paper analyses Krugman's contention that there is a `gold standard paradox' in the speculative attack literature. The paradox occurs if a country's currency appreciates after it runs out of gold or equivalently if a speculative attack can happen only after the country `naturally' runs out of reserves. We first show that Krugman's paradox is a very general phenomenon, which does not require mean-reverting processes for the fundamentals, and which can be present in discrete-time as well as in continuous-time models. We present several specific cases in which the paradox occurs, i.e., environments which do not support an equilibrium. Next we show that, contrary to Krugman's conjecture, it is not necessary to abandon the assumption of a perfectly fixed exchange rate in favour of a band system in order to recover a well-defined equilibrium. We propose two alternative ways of amending the model which produce an equilibrium and preserve the fixed exchange rate assumption.