Speculation and the Crawling Peg

Abstract

The objective of this paper is to determine how speculative capital flows, as described by the modern stock equilibrium theory, affect the stability of the path of the exchange rate under crawling peg systems. Because of the recent emphasis on objective indicators in discussions of reform of the international adjustment mechanism, the paper investigates this question with a single-country model in which the rate of crawl chosen by the authorities depends on both the level and rate of change of the country's reserves. The model therefore embraces as special cases a pure reserve change target system, originally proposed by Meade (1964) and Williamson (1965) and more recently expounded by Cooper (1970), and a pure reserve stock target system, exemplified by Willett's (1970) plan and the recent proposal of the US Government (1973). The principal finding of this paper is that speculative capital movements destabilize the hybrid target and the pure reserve change target systems because exchange rate expectations are likely to be partly extrapolative. Such expectations also destabilize a pure reserve stock target system if the authorities glide the exchange rate too quickly or if an upward crawl of the country's exchange rate produces a net speculative capital'inflow. Furthermore, to determine whether either condition exists requires accurate knowledge of the parameters underlying speculative capital movements. Throughout the paper I will assume that domestic variables that influence the balance of payments-output, the price level and interest rates-are exogenous. The authorities can control interest rates by employing sterilization operations, but they do not use them to prevent speculative capital flows. With the exchange rate now available for external purposes, the central bank can concentrate its monetary policy on domestic objectives.