DP879 A Model of the ERM Crisis

Author(s): F Gulcin Ozkan, Alan Sutherland
Publication Date: January 1994
Keyword(s): Balance of Payments Crises, EMS, ERM, Speculative Attacks
JEL(s): F31, F32
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=879

Existing models of exchange rate crises do not provide a good explanation for the breakdown of the ERM in 1992<196>3. This paper presents an alternative model which captures some of the important features of that period. The switch from a fixed to a floating rate is triggered by an optimizing government that wants to loosen monetary policy and boost aggregate demand. Agents in the foreign exchange market know the government's objective function and therefore build expectations of a regime switch into interest differentials. It is shown that this interaction between private sector expectations and government preferences can imply a breakdown of the fixed rate sooner than the government would like.