How To Avoid Self-fulfilling Crises

Abstract

Obstfeld (1994) shows that a currency crisis can be explained by the occurrence of multiple equi- libria (2 interior equilibria). For the same level of economic fundamentals, it may be optimal for the government either to devalue or to maintain the peg. The decision depends on the inßationary expectations of economic agents: it is the phenomenon of self-fulÞlling crisis. In order to avoid this kind of crisis, this article offers a new proposal: a partial delegation of exchange rate policy to a more inßation-averse central banker. It shows that if the government continues to decide whether to main- tain the peg while the central banker chooses the magnitude of any realignment, lower inßationary expectations will lead to the existence of only one equilibrium. The probability of crisis will then be considerably reduced and a currency crisis will occur only if negative shocks substantially damage the level of economic fundamentals.