Self-fulfilling risk predictions:: an application to speculative attacks

Abstract

We show that changing market beliefs about currency risk can generate a self-fulfilling speculative attack on a fixed exchange rate. The attack does not require a later change in policies to make it profitable. We illustrate this point by introducing an endogenous risk premium into a “first-generation model” of a speculative attack. The model is further modified to take account of sterilization, debt-financed fiscal deficits and anticipatory price-setting behavior. We use the model to interpret the 1994 Mexican peso crisis.