DP5876 Discrete Devaluations and Multiple Equilibria in a First Generation Model of Currency Crises

Author(s): Fernando A Broner

Publication Date: October 2006

Keyword(s): currency crises , first generation models , private information , discrete devaluations , multiple equilibria

JEL(s): D8 , E58 , F31 , F32

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5876.asp.asp

The first generation models of currency crises have often been criticized because they predict that, in the absence of very large triggering shocks, currency attacks should be predictable and lead to small devaluations. This paper shows that these features of first generation models are not robust to the inclusion of private information. In particular, this paper analyzes a generalization of the Krugman-Flood-Garber (KFG) model, which relaxes the assumption that all consumers are perfectly informed about the level of fundamentals. In this environment, the KFG equilibrium of zero devaluation is only one of many possible equilibria. In all the other equilibria, the lack of perfect information delays the attack on the currency past the point at which the shadow exchange rate equals the peg, giving rise to unpredictable and discrete devaluations.