Defending AgainstSpeculative Attacks : A HybridModel of ExchangeMarket Pressure and Crises

While virtually all currency crisismodels recognise that the fate of a currency peg depends onhow tenaciously policy makers defend it, they seldom model how this is done. We incorporatethemechanics of speculation and the interest rate defence against it in the model ofMorrisand Shin (American Economic Review 88, 1998). Our model captures that the interest ratedefence reduces speculators’ profits and thus postpones the crisis. It predicts that wellbefore the fall of a currency interest rates are increased to offset the buildup of exchangemarket pressure, and this then unravels in a sharp depreciation. This pattern is at odds withpredictions of standard models, but we show that it fits well with reality.