Exchange Rates
Speculative market structure

A salient feature of recent currency speculations in the Exchange Rate Mechanism is that the speculators can be big strategic players in the market, along with the central bank. In Discussion Paper No. 1164, Research Affiliate Zhaohui Chen develops a game-theoretic model that captures this feature of the speculative market, concentrating on the short-run dynamics of speculative attacks. For a regime with a narrow fluctuation band, the analysis identifies the following factors affecting the equilibrium exchange rate movement: the cost and benefit considerations for both the speculator and the central bank, and the credibility of the band. The analysis also provides a framework for evaluating the effectiveness of different anti-speculation policy instruments, including reserves, interest rates, and capital controls. It suggests a potentially useful scheme that penalizes the speculators only on their post-speculation gains, a `windfall tax'.

For a wide band regime, the paper shows the possibility of multiple equilibria, giving rise to a `wall within the wide band'. Such a wall serves as a barrier to exchange rate movements and therefore helps stabilize exchange rate fluctuations, although it does not eliminate the possibility of the collapse of the system. The model implies a U-shaped unconditional distribution for the narrow band and a W-shaped distribution for the wide band. The paper also provides an analytical framework for other policy issues. The proposal for increased coordination among central banks and the supply of `unlimited' reserves can be seen as a positive step that would increase the credibility of the exchange rate band. The puzzle that raising interest rates does not necessarily attract capital reflow can also be explained in the framework of the paper.

Speculative Market Structure and the Collapse of an Exchange Rate Mechanism
Zhaohui Chen

Discussion Paper No. 1164, May 1995 (IM)