Optimal Policy Response To Speculative Attack

Abstract

This paper intends to provide a framework on the optimal policy of developing economy in response to speculative attacks. It is also related with the issue of pegging vs flexible exchange rate system and the optimal commitment to a fixed rate. I borrow the model by Lahiri and Vegh(2001), and extended it in order to provide general guidelines useful for the case of currency crisis. The model in this paper incorporates three key frictions: an output cost of nominal exchange rate fluctuations, an output cost of higher interest rates to defend the currency, and a fixed cost of intervention. The optimal policy response of developing economy faced with currency crisis can be influenced by three contexts; size of shock, source of shock, economic fundamentals. 1. If small shock, no intervention by depreciating the currency depreciate is desirable. If large shock, the output costs is too large compared to the intervention cost, and it is optimal to stabilize the exchange rate with Intervention. 2. If Monetary Shock, fixed FX system works better for insulating the real side of the economy from monetary shock. If Real Shock, flexible FX system works better because real shock changes the real wages. 3. If Weak fundamentals, the output costs are unbearable and no intervention is desirable. If Strong fundamentals, the output costs are endurable and intervention to stabilize the exchange rate is desirable.