Rational Speculation, Financial Crises, and Optimal Policy Responses

February 1, 2004

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Format: Chicago

Jay Surti. Rational Speculation, Financial Crises, and Optimal Policy Responses, (USA: International Monetary Fund, 2004) accessed September 19, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

This paper develops a theory of the onset of financial crises by solving for the optimal trading strategies of speculators in financial markets, in a model where each speculator tries to coordinate her trades with the market's by observing the decisions of other speculators, while simultaneously trying to preempt the market. The interaction and resolution of these two conflicting incentives are analyzed under alternate central bank policy regimes. Our model explains how imperfect information structures prevent traders from exploiting profitable opportunities and suggests how large traders help alleviate this problem by undertaking risky arbitrage early in the investment process, in return for higher profits, if successful. The central bank's defense strategy is a parameter of this model. We compare the likelihood of a crisis under alternate defense strategies and show that credible monetary authorities can provide a better defense of exchange rate regimes against adverse shocks by not disclosing their commitment value to the market.

Subject: Banking, Currencies, Exchange rate arrangements, Financial crises, Liquidity

Keywords: Equilibrium market dynamics, Financial market, Liquidity constraint, Market expectation, WP

Publication Details

Pages:

28
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2004/025
Stock No:

WPIEA0252004
ISBN:

9781451844290
ISSN:

1018-5941

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