In Discussion Paper No. 1239, Gareth Davis and Research Fellow David Vines present a simple canonical model where they study the interaction between the foreign interest rate, the domestic interest rate and expectations of collapse and show the conditions under which there will and will not be multiple equilibria. A shock to the foreign interest rate has both a direct and indirect effect on the domestic interest rate and hence on domestic output, in each case via the uncovered interest parity condition. Thus, the sustainability of a fixed exchange rate regime in the presence of stochastic shocks to the economy becomes state-dependent. This state-dependency has implications for private sector behaviour, and the resulting expectations of a possible regime switch increase the likelihood of an actual switch in the model.

Such equilibrium crisis models may also have multiple equilibria. The economy may jump between one equilibrium where depreciation expectations are low and the regime is relatively easily sustained, and one where depreciation expectations are high and the fixed exchange rate regime is therefore vulnerable. Alternatively, hysteresis is possible. Lastly, the observed behaviour will depend on the assumptions regarding the speed of adjustment of private sector expectations. In a self-fulfilling crisis, instantaneous and costless expectational adjustment is assumed, allowing jumps between the potential equilibria. If expectations are costly to adjust, however, the picture changes. Expectations will adjust only slowly, and the equilibrium will become history-dependent, ruling out any unstable equilibria. Initial expectations will prove critical for sustainability of the regime when the cost of quitting changes.

Equilibrium Currency Crises: Are Multiple Equilibria Self-fulfilling or History Dependent?
Gareth Davies and David Vines

Discussion Paper No. 1239, September 1995 (IM)