DP1164 | Speculative Market Structure and the Collapse of an Exchange Rate Mechanism

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31/05/1995

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Abstract

A salient feature of recent currency speculations in the European Exchange Rate Mechanism is that the speculators can be big strategic players in the market, along with the central bank. This paper develops a game-theoretic model that captures this feature of the speculative market. For a regime with a narrow fluctuation band, the analysis identifies the following factors affecting the equilibrium exchange rate movement: the cost and benefit considerations for both the speculator and the central bank, and the credibility of the band. The analysis also provides a framework to evaluate the effectiveness of different anti-speculation policy instruments, including reserves, interest rates, and capital controls. It suggests a potentially useful scheme that penalizes the speculators only on their post-speculation gains (a `windfall tax'). For a wide-band regime, this paper shows the possibility of multiple equilibria, giving rise to a `wall within the wide band'. Such a `wall' serves as a barrier to exchange rate movements and therefore helps stabilize exchange rate fluctuations, although it does not eliminate the possibility of the collapse of the system. The model implies a U-shaped unconditional distribution for the narrow band and a W-shaped distribution for the wide band.