Defending against Speculative Attacks

While virtually all modern currency crisis models recognise that the decision to abandon an exchange rate peg depends on how tenaciously policy makers are willing to defend it, they seldom model how this is done. We incorporate both the mechanics of speculation and of a defence policy against speculation - based on raising the interest rate - in the well-known currency crisis model of Morris and Shin (American Economic Review 88 (1998), 587-97). After adding these natural elements, our model outperforms standard models at explaining stylised features of currency crises. Moreover, our model with endogenous policy responses connects the theoretical currency crisis literature to the literature on exchange market pressure, by bringing together its building blocks: exchange rate changes plus counter-acting defence policies. We use this connection to confirm our model's predictions empirically