Speculative Attacks and the Dynamics of Exchange Rates

Stephen J. Turnovsky

This paper examines the issue of speculative attacks on the exchange rate in an economy in which. following the attack the government allows the exchange rate to float for a limited period, before repegging it at a higher, sustainable, level. We highlight the tradeoffs between the length of the floating rate period and the timing of the speculative attack, and the implied consequences for the time paths of the exchange rate and consumption. By letting the exchange rate float for an appropriate period, the exchange rate crisis can be delayed for a maximum period of time, although delaying the crisis as long as possible is non-optimal. In some respects our results are qualitatively similar to earlier results based on non-optimizing models, although employing a rational intertemporal optimizing framework substantially enhances our understanding of the determinants of the crises.