Defending against speculative attacks – It is risky, but it can pay off

Abstract

While currency crises are typically considered to be painful and costly events, a closer look reveals that economic developments after a speculative attack differ considerably. Monetary authorities can play a central role in determining the economic course and costs of currency crises. They have to decide whether to defend or not to defend the domestic currency giving rise to three different types of crises: (i) an immediate depreciation if the central bank does not intervene and either (ii) a successful defense or (iii) an unsuccessful defense in the case of an intervention. We find that a central bank has two options to mitigate the costs of speculative attacks, namely an immediate depreciation and a successful defense. If a central bank intervenes she might be able to stabilize the exchange rate only temporarily and risks to ultimately fail facing the worst of the three scenarios with the highest economic costs.