Speculative attacks in a two-peg model

Abstract

We present a two-country model of speculative attacks where the two countries peg their currency to the U.S. dollar and a continuum of investors can either attack or defend one or the two pegs. The main objective of the paper is to show how extending a single-peg model of speculative attacks with the presence of a second country pegging its currency changes the range of parameters for which a currency is attacked. The model suggests that the presence of another country fixing its exchange rate changes dramatically the range of parameters for which a currency is attacked or defended. For example, the model indicates that a peg with a relatively high probability of collapse could survive if the other peg is not very likely to be abandoned, so investors prefer instead to defend the second peg. Finally, under complete information, when the level of fundamentals in both economies is neither weak nor strong the stronger peg may collapse while the weaker peg may survive, so in principle any peg could be successfully attacked.