Imperfect Common Knowledge in First-Generation Models of Currency Crises

by Gara Mínguez-Afonso
London School of Economics

Abstract

First-generation models assume that the level of reserves of a central bank is common knowledge among arbitrageurs, and therefore the timing of the attack on the currency can be correctly anticipated. The collapse of the peg thus leads to no discrete change in the exchange rate. We relax the assumption of perfect information and introduce uncertainty about the willingness of a central bank to defend the peg. In this new setting, there is a unique equilibrium at which the fixed exchange rate is abandoned. The lack of common knowledge will lead to a discrete devaluation once the peg finally collapses. 

JEL Codes: D82, E58, F31.

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