Download NBER WORKING PAPER SERIES COMPETITIVENESS, REALIGNMENT, AND SPECULATION: Maurice Obstfeld

NBER WORKING PAPER SERIES
COMPETITIVENESS, REALIGNMENT, AND SPECULATION:
THE ROLE OF FINANCIAL MARKETS
Maurice Obstfeld
Working Paper No. 2539
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
March 1988
Presented at the Conference on the EMS, Perugia, October 16—17, 1987, organized
by the Banca dItalia, the Centre for Economic Policy Research, and the Centro
Interuniversitarlo Studi Teorici per la Politica Economica. The research reported
here is part of the NBERS research program in International Studies. Any opinions
expressed are those of the author and not those of the National Bureau of Economic
Research.
NBER Working Paper #2539
March 1988
CornpetitivenessRealignment, and Speculation:
The Role of Financial Markets
ABSTRACT
Current and
capital accounts of
France and
continued viability of
the
realignment followed to
date
(EMS).
This
external
planned measures liberalizing the
Italy call
policy
in
the
of
into question the
periodic exchange-rate
European Monetary System
paper is intended as a first step in studying the real
and monetary effects of EMS-style realignments in
free cross-border financial flows.
The
a
first set
derived concerns a situation in which there are
no
setting of
of
results
fundamental
factors behind domestic inflation. Under a policy regime in which
domestic inflation automatically triggers devaluation, the economy
can
undergo
self-fulfilling
depreciation-inflation spirals,
triggered by speculative attack on the exchange rate. Such spirals
do not occur when realignments do not offset past inflation fully.
The second set of results shows how an exchange rate collapse can
occur after inflation is set off by
expansionary fiscal policy.
Sometimes, but not always, the crisis will be preceded by a period
of capital inflows and real currency appreciation.
In other cases
fiscal expansion may set off an immediate crisis.
Maurice Obstfeld
National Bureau of
Economic Research
1050 Massachusetts Avenue
Cambridge, MA 02138
(617) 868-3900,
ext.
33
Introduction
Since its
March
inauguration in
the
1979,
mechanism of the European Monetary System
exchange-rate
has
(EMS)
functioned
with the aid of frequent currrency realignments--to date,
than one per year on average. In the eyes of many
more
the
observers,
strategy of frequent realignment has allowed the system to survive
in spite of the rather divergent macroeconomic policies pursued by
the
"Big Three" of the
EMS,
France,
I
and
Germany,
An
Italy.
apparently critical element in minimizing the financial disruption
caused by realignments has
financial flows
been
the
maintained by
France and
onshore-offshore interest differentials
currency crises suggest that
control over
The
Italy.
that have
emerged
capital controls have
French and
important role in insulating the
systems from the full force of speculative
Current
cross-border
France
and
Italian financial
capital movements.
Italy call
into
external
question the
continued viability of a widely-understood EMS policy of
realignment.
Yet the speculative
that
attention in the academic literature.2
The
the role parity changes
puzzling:
empirically,
an
response of
area
expected parity change is
play
in
during
played an
and planned measures liberalizing the
capital accounts of
large
flows
capital
has
periodic
to
received little
relative
neglect of
balance-of-payments crises is
devaluation fears are
the leading- -factor behind currency flight,
inflows are often inspired by hopes of
a
just
leading- -perhaps
as
revaluation.
speculative
A
further
shortcoming of the existing literature is that, for the most part,
it stops
short
of
analyzing the
possible real
macroeconomic
effects of exchange-rate crises.
This paper is intended as a first step in studying the
real
and monetary effects of EMS-type realignment policies in a setting
A
financial flows.
of free cross-border
simple model that serves
as the paper's analytical framework is sketched in Section 1.
precise question then asked
What
is:
kinds
arise when markets expect a loss of home
foreign goods to lead to realignment?
of
The
equilibria can
against
competitiveness
Although much work
remains
to be done, the results of a preliminary investigation are
quite
suggestive.
The first set of results, described in Section 2, concerns a
situation in which there
are
no
fundamental
fiscal expansion) behind domestic inflation.
factors
as
(such
Section
Instead,
analyzes the economy's behavior under exchange-rate rules
2
that
allow cumulative inflation to trigger realignment automatically.
The key finding is that such rules can induce multiple equilibria.
Specifically,
if realignment is expected to maintain
external competitiveness,
enhance
or
the economy has two equilibria.
these involves an inflationary spiral in which speculators
collapse of the fixed exchange rate
currency to its new peg.
and a
One
of
force a
depreciation of
the
When realignment is expected to aim at a
real appreciation of the domestic currency, however, there is only
one equilibrium:
These
mobility,
the inflation-depreciationspiral cannot occur.
results
suggest
that
under
conditions of
a systematic realignment policy
may have
effects--in financial markets, in the output and
capital
disruptive
labor
markets,
and on domestic inflation. Although the results are model-specific
and therefore should not be taken too literally, they also provide
a
rationale for
the
offsetting differential
A
recent EMS
practice of
only partially
inflation through currency realignment.3
second set of results,
explained in
Section
3,
studies
inflation
expected realignment in a setting where domestic price
is already being driven by fundamentals
(here, fiscal
how
The possible equilibria of the economy depend on
authorities attempt to
offset past
expansion).
the
fully
inflation through currency
If devaluation is large relative to past inflation,
depreciation.
an exchange-rate collapse occurs as soon as an expansionary fiscal
policy is enacted, but before any real appreciation has
In the face of smaller devaluations,
the fixed exchange rate
domestic inflation for
coexist with
occurred.
some
time
can
before
the
setting
for
inevitable collapse occurs.
1. The Mode].
A
simple model with sticky output prices is the
the discussion;
in line with the
financial
likely evolution of
arrangements within the EMS, perfect capital mobility is
Three basic hypotheses are (1) that the exchange rate
entirely through the interventton of the home
that
the
a sense to be
made precise
fixed exchange rate must
temporarily)
once
this
capacity has
been
pegged
and
model
on
These
exhausted.
which
more
(3)
least
(at
hypotheses do not square perfectly with the facts of the EMS,
they lead to a useful benchmark
(2)
defend
to
below),
abandoned
be
is
central bank,
that the home central bank has only a limited capacity
the exchange rate (in
assumed.
but
realistic
analyses can be built.
The
analytical framework is
the
overshooting model
Dornbusch (1976) and Mussa (1977), as set out
Obstfeld and
Stocknian
(1985).
In
the
in
the
of
survey by
following description,
variables other than interest rates are natural logarithms,
and
a
variable such as Dz(t) is the (right-hand) time derivative of
time t.
Perfect
z at
foresight is assumed, so no distinction is
made
between actual and expected rates of change.
substitution between
With free capital mobility and perfect
domestic- and
onshore
the
foreign-currency bonds,
domestic
interest rate, i(t), is related by interest parity to the
i*,
depreciation,
De(t):
(1)
i(t)
—
the
and
foreign rate,
expected rate
of
(fixed)
domestic currency
i* + De(t).
The exchange rate e(t) is the price of foreign currency in
terms
of domestic.
If m(t) is the home
money
supply,
the
y
domestic output, and p(t) the money price of
level
(fixed)
output,
of
equilibrium
in the money market occurs when
(2)
m(t) -
p(t)
Let p* be
—
-yy
the
-
Ai(t).
(fixed)
foreign-currency price
output, which is distinct from domestic output.
of
foreign
Aggregate demand
for domestic output is
(3)
d(t)
—
[p* + e(t) p(t)]
-
-
[i(t)
-
Dp(t)].
Because the price of home output is sticky, aggregate demand
and
supply can differ in the short run.
Imbalances in
adjustment,
however,
the
output market contribute
and the model's
to describe price dynamics.
Let
(t)
to
final element is an
price
equation
denote the output price that
5
would currently clear the goods market; as in Mussa
this
(1977),
price is defined as the solution to
(4)
y —
p* + e(t) (t)]
-
-
o'[i(t)
Dp(t)J.
-
Then the inflation rate is given by
(5)
Dp(t)
where
9
9[d(t)
—
-
yl
+
Dp(t),
inflation to
measures the sensitivity of
demand. The
in
second term
equation
discussion below, as it captures the pure effects of
expectations
zero. Then for
a constant money
stock,
the exchange rate and price level are
p(t),
the
inflationary
on the price level.
that i*, y, and p* are
Assume now (for notational simplicity)
stationary
to
central
is
(5)
excess output
value
in,
the stationary values of
e()
—
p(')
of the real exchange rate, x(t) —
—
is therefore x(v) —
and
in,
p*
0. Under a floating exchange
+
the
e(t)
rate,
are given
dynamics of convergence to this long-run equilibrium
the
by
the pair of differential equations
(6)
De(t)
—
[p(t)
-
(7)
Dp(t) —
9[e(t)
-
e()J
(see Obstfeld and Stockman,
+
(
-
9)[p(t)
-
p()}
l985).
Figures la and lb show the two possible configurations
system described by the preceding two equations.
model has the familiar saddlepath property:
In each case the
for any initial price
level p(O), there is a unique equilibrium exchange rate
e(O), consistent with
the
of the
on
SS,
economy's eventual arrival at
its
zO
p
p()
A
(a)
m
p(o)
e(a)me(O)
(1< X&4)
e
A
p
(b)
p()=
e():m
(i>X64)
e
6
long-run position. Also shown in
AA, which play
saddlepaths
diagrams are
the
important role
an
in
the
the
"anti9
analysis
below.
The two roots of the system are 1/A and
that
a general solution takes
(8)
e(t) -
e(o) — k1exp(t/))
(9)
p(t) -
p()
where k
=
-
-
p(t)
Setting k2
(11)
—
p(t)
p()
shown
(l/A9)kexp(-8t),
kexp(t/X) + kexp(-9t),
Setting k — 0 gives the equation for
(10)
it can be
the form
are parameters determined by
and k
-9;
—
-A9[e(t)
-
initial
conditions
SS:
e()].
0 gives the equation for AA:
—
e(t).
The unstable path AA thus
coincides with
a
450
ray
from
the
origin.
2. Inflation and Realignment:
Self-fulfilling Equilibria
To focus on the pure effects of
an
anticipated realignment
policy, the model abstracts in this section from all
that might
alter the
long-run equilibrium level
competitiveness.
The model thus concentrates
alone, and asks
if
conditions,
on
disturbances
of
external
monetary factors
even under these relatively uflcomplicated
expected realignments can have disruptive effects on
the macroeconomy. In particular,
can expected realignments lead
7
to
equilibria that look like inflation-devaluationspirals?
The answer depends on the
exchange rate.
mechanism in
to
place
fix
the
Here I assume that the policy authority allows the
exchange rate to float once private capital outflows have
reduced
the domestic money stock to a positive lower bound of m0.
Such
a
situation would arise, for example, if the central bank's external
credit lines provided insufficient foreign
exchange to
outstanding domestic credit and if other tools
purchase
reducing the
for
domestic component of the monetary base were unavailable.
policy authority must
The realignment rule followed by the
now be
fixed at the level
and that
determined money stock
e'
the
in
—
p
is
initially
corresponding long-run price
<To these prices there
level is p.
authority's
exchange rate
Imagine that the
specified.
+ 7y
corresponds an
Ai*
-
—
.)
endogenously
The
rule is to devalue the currency to an exchange rate of
> p.
if the price level reaches the trigger value of
>
Suppose first that
condition is
authorities
policy
.
e'
that when
p
reaches
The
the
trigger
devalue the currency to a level that
restores current external competitiveness
of
this
point,
the
interpretation
to its
<at
a
minimum)
long-run value.
Clearly, one equilibrium of the model is the one in which
nothing
happens and the economy remains at the initial equilibrium,
p —
.
p ever
With no shocks disturbing markets, there
e
is no reason
—
for
to reach its trigger level and bring the realignment policy
into play.
There is,
Figure
2.
generality,
one.)
<The
however,
a
analysis henceforth assumes,
that the configuration of Figure la
In this equilibrium,
illustrated in
second equilibrium,
of
without
loss
is
relevant
the
speculators mount an attack
on
the
0
0
E
a)
0
E
0
currency
rule becomes
as soon as the realignment
m
capital outflows reduce the money supply to
central bank to withdraw from the
Private
known.
force
and
the
the
foreign exchange market:
economy is know on an unstable path of
the
floating-rate system
associated with a money supply equal to the minimal level m.
The
collapse results in a sharp currency depreciation [to e(O)], after
'
which e and p rise together in an
,
When p reaches
e —
and
rate at this new level if no
Subsequently,
inflation-depreciation spiral.
the central bank can peg the exchange
further realignment is
expected.5
rising domestic prices erode any short-term gain
in
competitiveness as p rises to its new long-run level, p' —
This second equilibrium is driven entirely by self-fulfilling
expectations that there will be a crisis followed by inflation and
a
Since a speculative attack causes a
realignment.6
depreciation
of the domestic currency, each speculator has an incentive to join
The immediate real
in if he believes an attack is about to occur.
currency depreciation helps pull
trigger price level is reached.
domestic prices
jump in the
asset-market
so there is no need for
exchange rate,
equilibrium
a
the
trigger price
discrete anticipated
which would be
inconsistent
with
1979).
Although
the
(Krugman
exchange-rate collapse causes an immediate real depreciation,
in
currency subsequently appreciates
transitional
the
In this alternative equilibrium,
the exchange rate reaches its new peg just as
level is reached,
until
up
float that precedes the
real
terms
return
to
during
the
the
realigned fixed
rates.
Perhaps surprisingly,
there
is
first of the two described above- -when
only
'
<
one
,
so
equilibrium- -the
that the
authority realigns without attempting to offset fully
the
policy
price
9
To
inflation that has occurred in the past.
Figure 3.
see
In the case shown there, the only
consider
this,
exchange-rate paths
avoiding a discrete jump at the moment of realignment call for
an
that drives the
appreciation of the currency just after the attack
central bank
from
the
no
occurs:
speculator would
individual
profitable to participate.
immediate
This
hypothesized speculative attack
appreciation means that the
fact never
market.
exchange
find
in
it
The economy thus remains at e — e, p —
if it is believed that the realignment policy
not
will
fully
offset past inflation.
To understand the difference between the present case and the
last one, observe that the post-attack change in the exchange rate
is influenced by two factors,
(from
to
m0)
the initial drop in the money supply
the
the expectation that
' in the
pegged at the level
be
The first factor pushes the
future.
price of foreign currency downward after the
pushes it upward upward.7
will
exchange rate
attack,
second
the
dominates when
The second factor
the
realigned exchange rate is more competitive because it is only by
depreciating initially that the real exchange rate can be
higher
also when the central bank re-enters the foreign exchange market.
The case
are possible.
exchange
—
a borderline case
In this case, the
given that p
in which both equilibria
authorities
maintains
that
rate
competitiveness,
is
is
the
at
peg
a nominal
level
of
trigger point.
The
original
the
at
initial speculative attack leaves the floating exchange
its pre-attack level
until p reaches p.
,
after
rate
at
which e and p rise together along AA
At this point the currency is again pegged and
the economy is at a new stationary position.8
CD
ml
(DI
CD
3
0
3
DDI
DII
0
10
3.
Attacks that Are
Justified by
Fundamentals
The previous section established the
existence of
Central
equilibria under an accommodative realignment rule.
the
discussion was
the
form
precise
of
the
exchange-rate rule: under alternative rules the
disappear.
multiple
to
authorities'
multiplicity can
If the policy rule is to realign only after
the
real
the
exchange rate has appreciated by a given amount, for example,
inflationary paths of the previous section are no longer supported
by the policy rule, because the attack that sets off the inflation
leads to
a temporary gain
This
in competitiveness,
section demonstrates
how
not a
prospective loss in external competitiveness
(In contrast,
due
can
attacks
speculative
nonetheless occur when realignment is prompted by
factors.
loss.
current
a
fundamental
to
the inflations prompting the
or
realignments
described in the previous section were entirely the result of
the
Once again, the behavior of the model
prospect of accommodation.)
turns on the degree to which the
authorities
attempt
to
offset
inflation through devaluation.
Under the posited conditions of a
interest parity,
fixed
exchange rate
continuing domestic-credit expansion by
and
the
authorities would lead to steady foreign reserve loss rather than
to real currency appreciation.
I therefore assume that the
of real appreciation is, instead, fiscal.
With a
source
fixed exchange
rate and a sticky price level, fiscal expansion induces temporary
excess output demand and thus
a
appreciates the currency in real
output-market equilibrium.
gradual price-level rise
terms
and
that
eventually restores
The specific scenario analyzed is
one
but
the
in which fiscal expansion sets off
domestic
inflation,
market expects the policy authority to devalue some
time
before
i-i
the full upward adjustment of the home price level is complete.
The model used in the previous sections can
allow for aggregate-demand shocks such
as
Write the aggregate-demand equation
as
d(t)
where g is
—
[p*
a
e(t)
+
p(t)]
-
demand-shift
p()
0.)
+
—
-g/,
Dp(t)J
-
The
p() — m, e()
extended to
shifts.
fiscal-policy
o'j:i(t)
factor.
floating-rate model becomes
-
-
(3)
be
+
g,
of
steady state
— m -
g/,
x()
e()
for any constant money supply m. (Recall that
p
The equation of the unstable linear path AA is now p(t)
g/:
a rise in
g
causes
the
—
e(t)
a parallel leftward shift of AA
in
Figures Ia and lb.
Figure 4 shows one example of how the economy can react to
fiscal stimulus followed by realignment.
Initially g — 0 and
the
long-run values of the price level and exchange rate are shown
p and
e;
a
rise in g sets
prices moving upward.
money supply must also rise over time, as
intervention,
a
to maintain equilibrium in the
long as the exchange rate remains fixed at
vertically toward point
E, the
,
the
,
official
"anti"
So
market.)
the economy moves
new long-run position that
eventually be reached In the absence of an
Point E lies on A'A'
money
as
nominal
(The
result of
a
would
exchange-rate change.
saddlepath associated with
a
permanent level g of the demand-shift parameter.
Assume now that the market expects the authorities to realign
the exchange rate at
once the price level reaches
.
In
this
case an attack occurs at point F, so that the economy is placed on
a path of the floating-rate system
associated with
the
minimal
money supply m0 <and the saddlepath 5' S'). The equilibrium path is
a-
w
1°-
0
E
S.
U)
1W
1W
E
12
reaches
at
jump in a takes place
No discrete
.
' just
reaches
the unique one with the property that a
as
p
moment
the
of
re-pegging (though there is a sharp capital inflow that raises m),
and the economy converges afterward to point C as inflation falls
on
Clearly the devaluation has no long-run effect
to zero.
cause a
real exchange rate, but it does
the
long-run price
higher
level.
Two features of the path
First, even though the
described deserve emphasis.
just
attack
eventual
is
there is an initial period following the
fiscal
In
which prices rise, the capital account is
exchange rate remains fixed.
real
Second,
competitiveness
continues
inflows and
crisis
in
the
late
occurs
,
which itself has a 45°
after
a
slope).
steady deterioration in
contrast to the example of the
last
is
l970s.
the
during
transitional period of floating (since p is rising faster
below A'A'
the
stabilization plans
deteriorate
to
and
surplus,
external
accompanied the
undertaken in Latin America's Southern Cone
during
impulse
The pattern of capital
currency appreciation followed by
reminiscent of events that
perfectly foreseen,
Thus,
than
e
realignment
competitiveness,
in
the
real
section.
exchange rate first depreciated (as a result of
There,
then
collapse),
appreciated as realignr3nt approached.
As Figure 5
shows,
possible. In Figure
for
a devaluation so
other
however,
5, the authorities'
adjustment paths
realignment
large that competitiveness is
restored to its original, pre-fiscal-expansion,
case the fiscal expansion sparks
nominal currency depreciation to
4
an
policy calls
(temporarily)
level.
immediate collapse
point F.
tmn1ete1v
The
are
In
this
and
a
associated real
reversed
durins
the
I0
w
0
U)
0
E
13
e'
transitional float that brings the economy to e
re-pegging,
there
a
is
further
loss
inflation brings the economy to point
in
p
,
p. After
as
competitiveness
Once again, there is
G.
ultimate gain in competitiveness as a result of the
no
exchange-rate
change.
The lesson of this example is
to
over-energetic attempt
structural shift
in
the
restore
real
expectation of
an
competitiveness despite
a
that
exchange rate
immediate run on the currency. Such runs
real appreciation emerges, and
the
thus
foundation in market fundamentals.
may
occur
can
set
even
to
appear
Nonetheless,
off
before
an
any
without
be
are
they
the
result of rational anticipations of future exchange-rate policy.
The fiscal policy shock analyzed here is
not
the
one
only
calling for a change in the long-run real exchange rate.
A
very
plausible situation involves expected devaluation after an adverse
shift in the demand for domestic exports.
could have the advantage,
n principle,
a devaluation
(Such
of shortening the
of recession that results from the shock.)
A
period
puzzling result
easy to verify using the techniques employed above:
is
In many cases
an equilibrium does not exist.
Obviously, much of the analysis above rests
assumption of
continu,us-time trading.
would allow devaluations
that were not
A
heavily
on
the
discrete-time model
preceded by
transitional
floats, although paths similar to those analyzed above would still
be possible.
Arguably,
the continuous-time trading assumption
reasonably close to reality.
is
14
4.
Implications and Extensions
The model examined above is simple, but its implications
stark.
A
through
policy of attempting to
real
domestic inflation
accommodate
lead
can
devaluation
rational-expectations
equilibria.
exchange crisis and
a
One
to
these
of
subsequent spiral of
multiple
involves
inflation
depreciation that ultimately leave the economy with a
higher price level and exchange rate.
partial
In contrast,
As noted in the
a
this
introduction,
an
and
permanently
accommodation--if credible--precludes the
equilibrium.
are
policy
of
inflationary
reasoning may
provide one rationale for the failure of EMS realignments
to fully
accommodate differential inflation in recent years.9
Exchange-rate crises can
also
in
arise
response
realignments that attempt to offset inflation due to
fiscal policy.
Inflation and real appreciation may
some time before
a
collapse occurs,
collapse is anticipated by
the
expansionary
continue for
even though an
A
market.
anticipated devaluation may, however, cause
to
eventual
sufficiently large
immediate attack
an
that itself postpones the inevitable real appreciation.
The
model used
above
clearly
leaves
many
unanswered
questions. For example, is a single-country analysis applicable to
situations in which several EMS
members may
intervening to
be
defend a parity?10 A related question concerns the equilibria that
arise when the authorities'
ability to
defend a
limited in the manner assumed above, so that the
and do purchase the entire money supply to
rate.
This possibility would appear to
rate
is
not
authorities can
defend the
exchange
the
multiple
rule
out
equilibria of Section 2, but not obviously to preclude the attacks
of Section 3, since the public could reduce its money holdings
to
15
zero just before devaluation.
At a deeper level, one must ask whether there
policymaker preferences that
might
generate
realignment rules examined in this paper.
raise difficult problems
for
are
the
All of these
economic analysis,
but
plausible
types
of
questions
they
are
central to understanding the present and prospective functioning
of the EMS,
Algebraic Analysis of Self-fulfilling Equilibria
Appendix:
algebraic analysis of
An
the
of
discussed in Section 2 clarifies some aspects
self-fulfilling
Such an analysis can be based on equations
paths.
solutions for
the general
the
equilibrium
inflationary
dynamic
(8)
and
(9),
system describing the
floating-rate model.
find
must
one
To construct an inflationary equilibrium,
transition time T and constants k 1 and k2 such that e(T) —
p(T)
that
—
e(t)
-
m
—
kexp(t/A)
-
p(t)
-
m
—
kexp(t/))
+
is,
(l/AO)kexp(-9t),
k2exp(-Ot),
when the post-attack floating rate
stickiness of
is
determined
One initial condition is
prices:
p(O)
,
—
So
there
parameters T, k1
are
is
given
implicitly by
A(T) —
where
( - in )
(T) —
three
unknown
2
equation
-
a
and k
The solution for T
(e'
in
given by
conditions--one initial, two terminal--to determine the
(12)
and
when e(t) and p(t) follow the equations
system with money supply m.
the
e'
a
- (p
-
m)exp(-OT)
m) + (l/AO)(p
exp(T/A)
-
-
m0)exp(-9T)
exp(-9T)
exp(T/A) + (l/A8)exp(-9T)
the
nonlinear
17
Note that as
Figure 6 illustrates how T is determined by (12).
-
,
(
A(T) -
m)/('
-
m)
-
at
'
A(T) and B(T) is guaranteed.
Intersections
Thus,
for
intersection of
least one
realignment rules such that
I,
-
while B(T)
T
are also
some nonacconunodative realignment rules, of course,
possible for
but these
do
have
to
appreciate immediately after the speculative attack that sets
off
not
define equilibria because
currency would
the
the inflation.
One case that is easy to analyze explicitly is the borderline
case referred to in the text, in which
.
'
In
case
this
the
solution to (12) is
—
T
Direct
are
Xlog[(
ni0)/(p0
-
is )].
calculation shows that the appropriate
—
k
-
- ni
and
k2
— 0,
which
imply
initial
that
the
conditions
equilibrium
floating exchange rate immediately after the attack is
e(O)
—
the original
peg.
After the attack, the exchange rate
moves toward its new peg along the
path
AA
in
Figure
therefore
2.
adjustment process is in this case a pure inflation that does
affect relative output prices.
The
not
TRANSITION
T INTERVAL,
t
T Equilibrium
4(T)
I
B(T) A(T),
18
Footnotes
*1 am grateful for helpful conversations with Cuillermo Calvo
and
in
Stephen O'Connell; for critical comments from participants
the
Conference on
the
especially
EMS,
and
Marcus Miller;
for
of
suggestions I received in a seminar at the Research Department
All errors are, however, my own.
the International Monetary Fund.
Financial support from the National Science
Foundation and
the
Alfred P. Sloan Foundation is acknowledged with thanks.
1.
Among recent
experience
of the EMS
reviews
are Collins (1987),
Giavazzi and Ciovannini (1986), Rogoff (1985), and Ungerer et
al.
(1986).
2.
Exceptions include Blanco and Garber (1986), Feenstra (1985),
Gros (1987),
and Obstfeld
(1984).
some of Feenstra's conclusions,
setting more descriptive of
As will become apparent below,
although reached
some
in
a
financial
developing economies than of
Europe, are quite relevant for analyzing prospective developments
in the EMS.
3.
See, for example, Giavazzi and Pagano (1988).
4.
Equations
under
(6)
and
(7)
follow from (1), (2), and the fact
price-adjustment rule
(5),
driven to its long-run value of zero
Dx(t)
5.
the
real
that
exchange rate
according to
the
is
equation
-Ox(t).
A similar response to anticipated devaluation
(1QS', 4r,
f
vihl
nr,' mndel
is
of currency
analyzed by
substitution
based on utility maximization.
contrast to
Notice that, in
case discussed in Obstfeld (1984), the length of the
transitional
6.
transitional
This is also true
period of floating is endogenous here.
of
the
example of
the
float analyzed in the next section.
The alternative equilibrium provides another
type of self-fulfilling crisis studied in my 1986 paper.
of
the
self-fulfilling accommodative policies is
The role
studied
in
a
different context by Corden (1986).
7.
See, for example, Flood and
Garber
(1983)
or
Obstfeld and
Stockman (1985).
8.
An algebraic analysis is given in the Appendix.
9.
A natural question
multiple equilibria by
is
whether
preventing,
speculative reserve outflows.
capital
or
Models of
at
controls
least
preclude
minimizing,
anticipatory wage
and
price setting, such as Calvo (1983), suggest a tentative negative
answer.
The question deserves a thorough analysis, however.
10.
a
For
clear account of EMS intervention arrangements,
paper by Mastropasqua,
Micossi,
and Rinaldi in this volume.
see the
References
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"Exchange Rate Depreciation,
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Horst Ungerer
Developments.
Achieved
European
Recent
D.C.: