Another interesting theory is the notion of self-fulfilling currency crisis (Obsfeld 1996)
•this notion asserts that whether a currency crisis occurs or not depends on how market participants view the future exchange rate.
•If the market participants expect that a sharp devaluation is impending, devaluation REALLY occurs. If they expect that the exchange rate stable, however, devaluation will not happen.
• Therefore, a currency crisis is self-fulfilling and multiple equilibria are possible: A currency crisis may or may not take place depending on the expectation of market participants.
case in point:
•hypothetical situation:
3 economic agents, a CB and investors A and B.
Ø The central bank is assumed to have a certain level of foreign reserves, R, which can be used for stabilization of the foreign exchange rate.
Ø Two players, A and B, are assumed to play a one shot non-cooperative game.
•Now suppose that two players have each 6 units of (domestic currencies), making use of two different strategies, keeping domestic currencies or selling domestic currencies and buy foreign ones.
•The payoff of this game depends on the amount of foreign reserves of the central bank.
(i) Case 1
•The central bank has 20 units of foreign reserves (denominated in domestic currency), i.e., R=20. Suppose that the transaction cost is 1 unit of domestic currency. Then the Nash equilibrium will be situation where both investors do not sell domestic currency .
(ii) Case 2
•R=6. In this case, if either one of the two investors sell domestic currency to buy foreign exchange, its foreign reserves will be soon depleted.
Ø The central bank is forced to devalue the domestic currency or let the exchange rate float.
Ø Assume that the central bank devalues the domestic currency by 50% when it cannot defend the fixed exchange rate with its foreign reserves.
Ø Because the investor who bought foreign reserves will have 3 units of capital gain and have to pay 1 units of transaction cost, he will have only 2 units of capital gain in his hand. If both investors A and B sell 3 units each to buy foreign exchange, then each investor will have only 1/2 (3/2-1).
Ø The Nash equilibrium is the case where both parties sell
(iii) Case 3
•assume R=10. Neither investor alone can deplete the central bank resources, although both can if they sell in concert. That is, devaluation cannot occur when only one investor attacks and the other does not because the central bank can defend the attack fully with its foreign reserves in hand.
•In this case the investor incurs only one unit of transaction cost. When both investors buy foreign reserves, they will each buy only 5 units of reserve. If the domestic currency is devalued by 50%, then both investors will have 5/2 units of capital gain and 1 units of transaction cost. The net benefit is therefore 3/2 units for each investor.
•Note that in this game two Nash equilibria emerge. One is where both investors buy foreign exchange and the central bank devalues the domestic currency.
•The other is where no investor sells domestic currency.
•This happens when one investor expects that the other will not sell domestic currency. And the central bank will not devalue. Therefore these multiple equilibria have an element of self-fulfilling expectation because currency crisis occurs if both investors expect a devaluation, while it does not occur when both do not expect a devaluation.
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