AModelofCommitmentStrengtheninginaFixedExchange.pptVIP

A Model of Commitment Strengthening in a Fixed Exchange Rate Regime Y. Stephen Chiu HKIMR and CUHK August 2001 Introduction Currency attacks may arise from neither bad fundamentals nor irresponsible domestic policies, but simply from a time consistency problem The time consistency problem--Ex ante, the government prefers to keep the peg. But upon a large scale attack, it prefers to abandon the peg. One remedy is to increase the devaluation cost the government incurs should the latter scenario arises. This mitigates the time consistency problem, and speculators will become less aggressive. Based on this idea, Chan and Chen (1999) and Miller (1998) proposed HK$ put option/structured notes to deal with currency crisis in HK in 1998. This paper builds up a theoretical model so that such a proposal can be evaluated. Model Stage 1: The fundamentals are sound, but bad fundamentals in the future cannot be completely ignored. Hence, the government attempts to strengthen its commitment to the peg (to choose D). Stage 2: the fundamentals are realized. Upon observing a private noisy signal x, each speculator decides whether to short sell one unit of local currency. Stage 3: Observing the fundamentals and the scale of attack, the government decides to defend or not. In the latter case, the currency will simply go afloat. What is commitment strengthening? Any means that increases the costs incurred by the government/policy makers upon a devaluation. Examples: Fixed rate being written down in the constitution compensation to the central banker contingent on whether the peg is maintained a voluntary transfer, upon a devaluation, to the Easter Island government to conserve its sculpture loans in US$ to authorized institutions giving the latter the option to repay in local currency at the pre-devalued fixed rate Version 1: a generic commitment device; no income is received by the government ex ante version 2: HK$put option/structured notes where the contract holders need to pay