Exchange Rates
Speculative attacks

During the European exchange market turmoil of 1992/3, it was evident that speculative attacks tended to spread across currencies. In Discussion Paper No. 1055, Research Fellow Stefan Gerlach and Frank Smets use a two-country version of the model developed by Flood and Garber (1984) to show how a speculative attack against one currency may accelerate the `warranted' collapse of a second parity. More importantly, even if the parity of the second currency is viable in the absence of a collapse of the first one, it might be subjected to a speculative attack if the reserves available to defend the parity are `small'.

The authors present a model which partially explains the contagion of speculative attacks. The economies are both assumed to operate a fixed exchange rate regime which, depending on the extent to which the central bank extends credit, may collapse. The forced depreciation of one currency, however, has real effects on prices and income in the other country through its effect on that country's competitiveness. This makes the collapse times interdependent. With excessive credit creation in both countries, it is shown that the collapse of the first exchange rate peg speeds up the collapse of the second fixed exchange rate regime. The reason for this is that the collapse of the first currency leads to a real appreciation of the second currency, which depresses income and prices in the second country. This in turn reduces the demand for money and causes a loss of foreign exchange reserves. With lower foreign exchange reserves, the ability to withstand a speculative attack is reduced, and the collapse of the second parity accelerated.

Furthermore, a parity that is otherwise sustainable may be attacked in the event of a successful attack on another currency. Thus, `unwarranted' contagion may occur. The authors also demonstrate that the contagion effects in the model are stronger the lower the degree of real and nominal wage flexibility, the higher the degree of trade integration between the two countries, and the less integrated the two countries are with the anchor country.

Contagious Speculative Attacks
Stefan Gerlach and Frank Smets

Discussion Paper No. 1055, November 1994 (IM)