Coordination and policy traps, Issue 9767
National Bureau of Economic Research, 2003 - Business & Economics - 36 pages
This paper examines the ability of a policy maker to control equilibrium outcomes in an environment where market participants play a coordination game with information heterogeneity. We consider defense policies against speculative currency attacks in a model where speculators observe the fundamentals with idiosyncratic noise. The policy maker is willing to take a costly policy action only for moderate fundamentals. Market participants can use this information to coordinate on different responses to the same policy action, thus resulting in policy traps, where the devaluation outcome and the shape of the optimal policy are dictated by self-fulfilling market expectations. Despite equilibrium multiplicity, robust policy predictions can be made. The probability of devaluation is monotonic in the fundamentals, the policy maker adopts a costly defense measure only for a small region of moderate fundamentals, and this region shrinks as the information in the market becomes precise. Keywords: Global Games, Coordination, Signaling, Speculative Attacks, Currency Crises, Multiple Equilibria. JEL Classification: C72, D82, D84, E5, E6, F31.
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active-policy equilibria aggregate demand aggressiveness of market arg max attacking the currency bank sets bank to raise bounded support central bank common knowledge compact support continuation equilibrium continuation game decreasing defend the currency devaluation occurs devaluation threshold domestic interest rate dominated in equilibrium environments equilibria of Proposition equilibrium outcome equilibrium policies finds it optimal global coordination game Hence idiosyncratic noise implies inactive policy equilibrium inactive-policy equilibrium increasing in 9 indifference conditions intuitive criterion test iterated deletion Lemma maintain the peg market participants market sentiments moderate fundamentals monotonic Morris and Shin Morris-Shin multiple equilibria NBER necessarily non-increasing Note Number observation paper payoff perfect Bayesian equilibrium policy choice policy maker policy r(9 policy traps private information private signal probability of devaluation Proof raise the interest random variable robust equilibrium signaling games speculative attack strategy strictly dominated strictly increasing subgame perfect equilibrium sunspot equilibria sustained Theorem threshold 9 two-threshold equilibrium