To Devalue or to Defend? The Political Economy of Exchange Rate Policy

TLDR

Speculative currency attacks are common, but not all lead to devaluation; often governments defend the peg. The study develops a model of strategic interaction between speculators and policymakers to explain currency attacks. The model represents strategic interactions between speculators in currency markets and policymakers in governments. The model finds that attacks occur when fundamentals are weak or defense capability is uncertain, and that governments defend the peg based on institutional, electoral, and partisan incentives.

Abstract

Speculative currency attacks are a regular feature of the international political economy. Nevertheless, not all speculative attacks result in a devalued currency. In many cases, politicians were willing and able to defend the exchange rate peg. I develop a model of strategic interaction between speculators in currency markets and policymakers in governments. This model indicates that speculative attacks occur when economic fundamentals are weak or when there is uncertainty about the capability and/or willingness of governments to defend the currency peg. I show that the government's decision to defend the peg reflects institutional, electoral, and partisan incentives. I test hypotheses from this model on a sample of 90 developing countries between 1985 and 1998 using a strategic probit model.