DP1201 | A Centre-Periphery Model of Monetary Coordination and Exchange Rate Crises

Publication Date

31/07/1995

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Abstract

The paper analyses the modalities and consequences of a breakdown of cooperation between the monetary authorities of inflation-prone periphery countries that use an exchange rate peg as an anti-inflationary device, when the centre is hit by an aggregate demand shock. Cooperation in the periphery is constrained to be symmetric: costs and benefits must be equal for all. Our model suggests that there are at least two ways in which a generalized crisis of the exchange rate system may emerge.The first is when the constrained cooperative response of the periphery is a moderate common devaluation while the non-cooperative equilibrium has large devaluations by a few countries. An exchange rate crisis emerges if periphery countries give in to their individual incentives to renege on the cooperative agreement. In the second case, the centre shock is not large enough to trigger a general devaluation in the constrained cooperative equilibrium; yet some of the periphery countries would devalue in the Nash equilibrium, making the monetary stance in the system more expansionary. In this case, reversion to Nash is collectively rational. We offer this model as a useful parable for interpreting the collapse of the ERM in 1992-3.