Currency Speculation in a Game-Theoretic Model of International Reserves

This paper is concerned with the ability of speculation to gener- ate a currency crisis. We consider a game-theoretic setting between a unit mass of speculators and a government that holds foreign currency reserves. We analyze conditions under which the speculators may be able to force the government to devaluate the currency. Among these conditions, we analyze the role of heterogeneous beliefs, transaction costs, the level of international reserves, and the widening of cur- rency bands. The explicit consideration of international reserves in our model makes speculators’ actions to be strategic substitutes— rather than strategic complements. This is a main analytical depar- ture with respect to related global games of currency speculation not including reserve holdings (e.g., Morris and Shin, 1998). Our sim- ple framework with international reserves becomes suitable to review some long-standing policy issues.