Balance-of-Payments Crises and Devaluation

Abstract

Abs t r actThe collapse of a fixed exchange rate is typically marked by a sudden balance-of-payments crisis in which "speculators" fleeing from the domestic currency acquire a large portion of the central bank's foreign exchange holdings.Faced with such an attack, the central bank often withdraws temporarily from the foreign exchange market, allowing the exchange rate to float freely before devaluing and returning to a fixed-rate regime.This paper links the timing of the initial speculative attack to the magnitude of the expected devaluation and to the length of the transitional period of floating.An implication of the analysis is that there exist devaluations so sharp and transition periods so short that a crisis must occur the moment the market first learns that the current exchange parity will eventually be altered.For sufficiently long transition periods, the floating exchange rate "overshoots" its new peg before appreciating back toward it; for shorter periods, the rate depreciates monotonically to its new fixed level.Accordingly, the central bank's return to the foreign exchange market can occasion a capital outflow or a capital inflow.

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