Abstract
The recent devaluation crisis in Mexico and its `tequila effect' elsewhere illustrate that two credibility problems associated with convertibility policies (currency boards) are announcements that violate truth-telling, and a non-zero probability of policy failure. We derive the trade-off between these problems when announcements resemble cheap talk. The strategic uncertainty created by this trade-off implies that both the government and investors should recognize the presence of `Fed watchers', who exploit any policy inconsistency for their own gain. In this context, credibility can be restored if the policy is coherent — if it eliminates the marginal benefits for Fed watching. (JEL E63, E58, F40). © 1997 Published by Elsevier Science Ltd.
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