Self-fulfilling Expectations Research Articles

Private and Public Information in Self-fulfilling Currency Crises

This paper analyzes the implications of currency crises in a model with unique equilibrium. Starting from a typical multiple equilibria model with self-fulfilling expectations we introduce noisy information, following Morris/Shin (1999). Under certain conditions for the noise parameter, all equilibria but one are eliminated so that we are able to derive comparative statics and subsequent policy devices. We can show that if the a priori expected fundamental state of the economy is good, there is an incentive for the government to disseminate very precise information. However, a high precision of public information increases the danger of an attack if ex-ante expected fundamentals are bad. Moreover, we find that the influence of private information's precision is exactly the reverse.

Did sunspot cause the Great Depression

We apply a dynamic general equilibrium model to the period of the Great Depression. In particular, we examine a modification of the real business cycle model in which the possibility of indeterminacy of equilibria arises. In other words, agents' self-fulfilling expectations can serve as a primary impulse behind fluctuations. We find that the model, driven only by these measured sunspot shocks, can explain well the entire Depression era. That is, the decline from 1929-1932, the subsequent slow recovery, and the recession that occurred in 1937-1938.

Sovereign liquidity crises: Analytics and implications for public policy

This paper offers an analytical framework with which to assess some recent proposals for strengthening the international financial architecture. We develop a model of sovereign liquidity crises that reflects two sources of financial stress – weak fundamentals and self-fulfilling expectations. We examine the nature of the underlying co-ordination game and investigate the properties of the unique equilibrium. In so doing, we are able to characterise the welfare costs of belief-driven crises, which we find to be potentially significant. We also evaluate some recent policy proposals including prudent debt and liquidity management, capital controls, greater information disclosure, and the efficacy of monetary policy tightening in the midst of crisis.

Fundamentals, beliefs, and financial contagion

We study contagion in a model in which financial crises can occur due to both weak fundamentals and adverse self-fulfilling expectations. Contagion emerges only if a crisis in one country leads international investors to rationally update beliefs about fundamentals in other countries. But purely expectational crises may be contagious, as investors may infer that fundamentals are weak. Hence, the structure of information is crucial. The analysis delivers useful lessons for assessing which countries are more vulnerable to contagion, which types of crises are more infectious, and whether increased transparency ameliorates contagion effects.

English Title Not Available [Turkish title: ENFLASYON HEDEFLEMESI: IKIZ KRIZLER: PARA KRIZLERI ILE BANKACILIK KRIZLERI ARASINDAKI BAGLANTILAR

Currency and banking crises have emerged jointly in many developing countries in recent years. This papers examines theoretical and empirical studies that consider links between currency and banking crises. In theory, both economic fundamentals and self-fulfilling expectations can contribute to emergence of these twin crises. It seems that financial liberalization plays an important role in emergence of twin crises. Financial liberalization with poor regulation and weak supervision can creates financial fragility. Furthermore, implicit or explicit goverment guarentees to bail-out the financial system may increae this fragility. On the other hand, a pegged exchange rate regime in such a financally liberalized environment, may make an economy vulnerable to a currency crises. The interaction between financial fragility and vulnerability to currency crises may increases severity of twin crises.

(Ir)Relevance of Currency Crisis Theory to the Devaluation and Collapse of the Thai Baht

This paper provides a detailed study of the crisis in Thailand with the goal of determining the usefulness of existing currency crisis theory to the breakdown of the baht's de facto dollar peg in 1997-98. We do not attempt to provide a comprehensive survey of the currency crisis literature; nor do we add directly to the empirical and theoretical literatures on currency crises. Rather, our goal in this paper is to examine, through the lens of the existing currency crisis literature, the sequence of events culminating with the devaluation of the Thai baht in July 2, 1997 and the financial and economic collapse thereafter. But why do we concentrate on Thailand in particular? First, the devaluation of the baht is widely acknowledged as the dawn of the East Asian crisis. Second, and in relation to this, given that Thailand was the first domino to fall, there seems to be greater debate/disagreement as to whether the Thai crisis was 'fundamentals-based' or due to 'self-fulfilling expectations'. Given our emphasis on Thailand, we do not address the issue of the reasons for the widening and deepening of the crisis from Thailand to the rest of East Asia and beyond (i.e. 'contagion').

The Effect of Statistical Discrimination on Black-White Wage Inequality: Estimating a Model with Multiple Equilibria

This paper presents the structural estimation of a statistical discrimination model where wage differentials can be generated by self-fulfilling expectations about group productivities. Although the model is capable of displaying multiple equilibria, an estimation strategy that identifies both the parameters of the model and the equilibrium chosen by the economic agents is developed and empirically implemented. The model is estimated three times using U.S. black and white male wage data from 1964 to 1996. In addition to recovering the selected equilibrium, all of the equilibria that the model could have displayed under the estimated set of fundamentals are computed. A comparison between the equilibria that were selected in the economy over time and the other potential equilibria reveals that the outcome with essentially the lowest wage inequality have been selected whenever the estimated parameters are consistent with multiple equilibria. This implies that self-fulfilling expectations did not exacerbate wage differentials in the U.S. and that the decline in wage inequality experienced in the U.S. economy in the last thirty years cannot be attributed to changes in the equilibrium selection. A simulation is also performed to compute equilibrium wages in a color blind society where employers cannot distinguish their employees for their ethnicity. Results show that black males' average wage would be 24.5% higher and whites' wage would be 2.2% lower.

Sovereign Liquidity Crises: Analytics and Implications for Public Policy

This paper offers an analytical framework with which to assess some recent proposals for strengthening the international financial architecture. A model is developed of sovereign liquidity crises that reflect two sources of financial stress?weak fundamentals and self-fulfilling expectations. The nature of the underlying co-ordination game is investigated, as are the properties of the unique equilibrium. In so doing, the paper characterises the welfare costs of belief-driven crises, which are found to be potentially significant. Some recent policy proposals are also evaluated, including prudent debt and liquidity management, capital controls, greater information disclosure, and the efficacy of monetary policy tightening in the midst of crisis.

Was Korea's Financial Crisis Self-Fulfilling

The second generation model, which emphasizes multiple equilibria and self-fulfilling expectations, is distinguished from its predecessors, which emphasize market fundamentals and unique equilibrium. However, a sudden outbreak of vulnerability that is triggered by market panic can also be explained by market fundamentals. This study shows that the Korean crisis was largely triggered by real appreciation, excessive lending, and a lack of adequate reserve protection, while expansionary fiscal and monetary policies as well as capital inflows were less central. Tests for a self-fulfilling crisis do not support the relationships among market fundamentals before the crisis. The real appreciation due to a weak yen and a strong won, excessive bank lending, and the mismanagement of foreign reserves led to the Korean crisis.

Global and Domestic Factors of Financial Crisis in Emerging Economies: Lessons from the East Asian Episodes (1997-1999)

This paper suggests that a new approach is needed in order to identify the causes of the East Asian financial crises and that this new approach might be fruitful in reassessing the analyses and theories of financial crises in emerging economies. The first part of the paper presents a new empirical analysis of the state of fundamentals in East Asia before the crises. It suggests that the relevant fundamentals were both non-conventional and (or not bad enough to trigger the crises by themselves). Fundamentals were also different from those preceding previous turmoils in the 1990s, such as the ERM crisis in 1992-1993 and the Mexican crisis in 1994-1995. The second part highlights that existing theoretical models of currency crises miss some important points. Even second generation models, which stress self-fulfilling expectations and which acknowledge that crises might appear against the backdrop of non-conventional and intermediate fundamentals, explain only the role of fundamentals in relation to private expectations. But they do not explain how can it be that a shift in private agents' expectations turns out into a financial crisis. The third part suggests that the current process of globalization exacerbates failures in international capital markets and impinges upon capital flows and the pace and order of financial liberalization in emerging economies, increasing therefore uncertainty and rendering large domestic vulnerabilities. It also highlights how financial globalization was related to the East Asian crises. The main conclusion is that intermediate non-conventional fundamentals, shifts in private agents' expectations and financial globalization were arguably the main factors of the East Asian crisis. Therefore, in order to prevent future financial crises, governments in emerging economies should try to exit crises zones through improving their fundamentals, to proceed carefully with financial liberalization, to implement some kind of capital controls and to urge for the establishment of a new global financial architecture.

Comment and Discussion

Local Corruption and Global Capital Flows Shang-Jin Wei The research reported in this paper was inspired by a plane ride I took from China to the United States in 1996. Browsing the newspapers and in-flight magazines, I came across one story about the high level of official corruption in China, and another that extolled the extraordinarily large flow of foreign direct investment (FDI) into China that year.1 Later in the flight, I struck up a conversation with the passenger sitting next to me, an American business executive who had just visited his joint venture firm in China. I asked him whether the corruption problem in China affected him and his business. He said that it did and went on to explain the myriad problems that his firm had encountered in dealing with corruption and bureaucratic red tape. During and after that flight, I reflected on whether corruption has generally worked as a beneficial “grease,” a minor annoyance, or a major obstacle for international investors. In this paper I address three interrelated issues. First, does corruption reduce inward FDI? Second, is China [End Page 303] an exceptional case in which corruption does not do much harm? Third, does corruption distort the composition of capital inflows in a way that might raise the likelihood of a currency crisis? International direct investment reached $3.5 trillion in 1997. A small number of countries in the industrial world account for the bulk—about 68 percent—of this investment.2 Yet international direct investment is especially important for developing countries, for which it is not only a source of scarce capital but also an important conduit for the transfer of technological and managerial know-how.3 The recent currency crises in East Asia, Russia, and Latin America have highlighted the importance of the composition of capital flows for developing countries. Before I attempt to explain the relationship between corruption and the composition of capital inflows, it is worth noting that there are at least two views on the causes of these crises. One increasingly widespread view is that so-called crony capitalism—the misallocation of financial resources to the friends and relatives of government officials—is partly responsible. However, there is so far virtually no systematic evidence to support or reject this hypothesis.4 The other view is that the confidence of international creditors in developing economies is fragile, so that small changes in the outlook can give rise to self-fulfilling expectations of a crisis. These two explanations are typically presented as rivals, but there may be a link between them. The extent of corruption in a country may affect that country’s composition of capital inflows in a way that makes it more vulnerable to shifts in international creditors’ expectations. Corruption here refers to the extent to which firms or individuals need to pay bribes to government officials to obtain permits, licenses, loans, or other government services needed to conduct business in a country.5 [End Page 304] Several studies have shown that the composition of international capital inflows is correlated with the incidence of currency crises.6 They have found that the lower the share of FDI in total capital inflows, or the higher the ratio of short-term debt to reserves, the more likely a currency crisis becomes. One possible reason is that bank lending or other portfolio investment may be driven more by sentiment than direct investment is. Hence a small, unfavorable change in the recipient country’s fundamentals may cause a large swing in portfolio capital flows, from massive inflows to massive outflows. This can strain the country’s currency or financial system sufficiently to cause or hasten its collapse.7 To my knowledge, no studies have examined the connection between corruption (or the intrusiveness of national bureaucracy more generally) and the composition of capital inflows. This paper seeks to fill that void. A small number of previous papers have looked at the effect of corruption on FDI. Combining corruption with twelve other variables to form a composite indicator, Ashoka Mody and David Wheeler failed to find a significant relation between corruption and foreign investment.8 However, this result may have been due to a...

Local Corruption and Global Capital Flows

THE RESEARCH REPORTED in this paper was inspired by a plane ride I took from China to the United States in 1996. Browsing the newspapers and in-flight magazines, I came across one story about the high level of official corruption in China, and another that extolled the extraordinarily large flow of foreign direct investment (FDI) into China that year.(1) Later in the flight, I struck up a conversation with the passenger sitting next to me, an American business executive who had just visited his joint venture firm in China. I asked him whether the corruption problem in China affected him and his business. He said that it did and went on to explain the myriad problems that his firm had encountered in dealing with corruption and bureaucratic red tape. During and after that flight, I reflected on whether corruption has generally worked as a beneficial grease, a minor annoyance, or a major obstacle for international investors. In this paper I address three interrelated issues. First, does corruption reduce inward FDI? Second, is China an exceptional case in which corruption does not do much harm? Third, does corruption distort the composition of capital inflows in a way that might raise the likelihood of a currency crisis? International direct investment reached $3.5 trillion in 1997. A small number of countries in the industrial world account for the bulk--about 68 percent--of this investment.(2) Yet international direct investment is especially important for developing countries, for which it is not only a source of scarce capital but also an important conduit for the transfer of technological and managerial know-how.(3) The recent currency crises in East Asia, Russia, and Latin America have highlighted the importance of the composition of capital flows for developing countries. Before I attempt to explain the relationship between corruption and the composition of capital inflows, it is worth noting that there are at least two views on the causes of these crises. One increasingly widespread view is that so-called crony capitalism--the misallocation of financial resources to the friends and relatives of government officials--is partly responsible. However, there is so far virtually no systematic evidence to support or reject this hypothesis.(4) The other view is that the confidence of international creditors in developing economies is fragile, so that small changes in the outlook can give rise to self-fulfilling expectations of a crisis. These two explanations are typically presented as rivals, but there may be a link between them. The extent of corruption in a country may affect that country's composition of capital inflows in a way that makes it more vulnerable to shifts in international creditors' expectations. Corruption here refers to the extent to which firms or individuals need to pay bribes to government officials to obtain permits, licenses, loans, or other government services needed to conduct business in a country.(5) Several studies have shown that the composition of international capital inflows is correlated with the incidence of currency crises.(6) They have found that the lower the share of FDI in total capital inflows, or the higher the ratio of short-term debt to reserves, the more likely a currency crisis becomes. One possible reason is that bank lending or other portfolio investment may be driven more by sentiment than direct investment is. Hence a small, unfavorable change in the recipient country's fundamentals may cause a large swing in portfolio capital flows, from massive inflows to massive outflows. This can strain the country's currency or financial system sufficiently to cause or hasten its collapse.(7) To my knowledge, no studies have examined the connection between corruption (or the intrusiveness of national bureaucracy more generally) and the composition of capital inflows. This paper seeks to fill that void. A small number of previous papers have looked at the effect of corruption on FDI. …

Contagion:: macroeconomic models with multiple equilibria

Several concepts of contagion are distinguished. It is argued that models that allow only a single equilibrium conditional on the macroeconomic fundamentals are not adequate to capture all forms of contagion, hence it is useful to formulate macro models that admit multiple equilibria and self-fulfilling expectations. A simple balance of payments model is presented to illustrate that phenomenon, and some back-of-the-envelope calculations assess its relevance to the coincidence of emerging market crises in 1994–95 and in 1997.

Expansionary fiscal contractions and equilibrium indeterminacy: a case study for Germany

On several occasions, the 1980s witnessed non-Keynesian effects of fiscal contractions. Most notably, cuts in government spending in Ireland, Denmark and Germany are known to have coincided with increases in private consumption spending. Self-fulfilling expectations about the effects of stabilization policies may explain these and a diversity of opposing experiences. This paper formulates a dynamic stochastic equilibrium model with equilibrium indeterminacy, which allows for sunspot fluctuations as well as for systematic consumption effects of government policy in either direction. Cointegration tests and Euler equation estimates suggest that the model is approximately in accord with German data. Parameter estimates imply that the non-Keynesian experiences are not due to self-fulfilling expectations but to the productivity effects of government-provided infrastructure services.

Has the Nature of Crises Changed? A L1812Quarter Century of Currency Crises in Argentina

The recent turmoil in currency markets in Asia, Europe, and Latin America has given a new impetus to the literature on currency crises. The literature originally linked currency crises to deteriorating economic fundamentals, but has more recently focused on self-fulfilling expectations and contagion. To assess the changing roles of domestic and external market fundamentals and contagion, this paper examines seven major currency crises in Argentina. It finds that while crises in the 1970s and 1980s were driven mainly by monetary and fiscal policies at home and abroad, contagion played an important role in the 1990s.

Has the Nature of Crises Changed? A Quarter Century of Currency Crises in Argentina

The recent turmoil in currency markets in Asia, Europe, and Latin America has given a new impetus to the literature on currency crises. The literature originally linked currency crises to deteriorating economic fundamentals, but has more recently focused on self-fulfilling expectations and contagion. To assess the changing roles of domestic and external market fundamentals and contagion, this paper examines seven major currency crises in Argentina. It finds that while crises in the 1970s and 1980s were driven mainly by monetary and fiscal policies at home and abroad, contagion played an important role in the 1990s.

Expectations Formation and Stability of Large Socioeconomic Systems

This paper attempts to identify, in a framework deliberately stripped of unnecessary technicalities, some of the basic reasons why adaptive learning may or may not lead to stability and convergence to self-fulfilling expectations in large socioeconomic systems where no agent, or collection of agents, can act to manipulate macroeconomic outcomes. It is shown that if agents are somewhat uncertain about the local stability of the system, and are accordingly ready to extrapolate a large range of regularities (trends) that may show up in past small deviations from equilibrium, including divergent ones, the learning dynamics is locally divergent. On the other hand, if agents are fairly sure of the local stability of the system, and extrapolate only convergent trends out of small past deviations from equilibrium, one may get local stability. This uncertainty principle does show up in a wide variety of contexts: smooth or discontinuous, finite or infinite memory learning rules, error learning, recursive least squares, Bayesian learning.

Global behaviour of a system with imperfect private–public substitutability

Empirical findings reveal that the relationship between private and public consumption generically differs from country to country: it is substitutable for some, while it is complementary for others. The present paper incorporates this regularity into a simple growth model with public goods which affect utility and production. The model casts off the standard assumption of socially constant returns to scale, and as a result it generates many interesting dynamic features, which do not arise with constant returns. When the system displays increasing returns, the dynamic path may diverge from an interior equilibrium in expanding oscillations, suggesting that self-fulfilling expectations could play an essential role. With decreasing returns, the interior equilibrium becomes a saddle point. Interestingly, it turns out that the substitutability versus complementarity distinction does make a difference in affecting the stationary state and its transitional dynamics.

Self-Fulfilling Expectations and Economic Growth: A Model of Technology Adoption and Industrialization

In this work, the authors construct a model that integrates both industrialization and endogenous growth. They feature the role of technology adoption in sustaining growth and achieving industrialization. The authors' economy contains multiple equilibria for an initial history. They found that only self-fulfilling expectations matter in selecting an equilibrium, whereas history plays no role. The authors' equilibrium is shown to involve a threshold property: when the economy starts above this threshold, the economy is able to sustain growth; otherwise, it is not. Both the rate of economic growth and the process of industrialization increase gradually and approach an upper hound. Copyright 1998 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Comparing Four Models of Aggregate Fluctuations due to Self-Fulfilling Expectations

This paper compares four equilibrium business cycle models with increasing returns to scale production technologies that allow for aggregate fluctuations due to self-fulfilling expectations. Necessary and sufficient conditions for the existence of stationary sunspot equilibria are derived. Numerical examples demonstrate that the degree of increasing returns necessary for the existence of stationary sunspot equilibria lies in the upper range of available empirical estimates. The paper also shows that persistent fluctuations are not a necessary property of these four models when the only source of fluctuations is changes in people's expectations about the future path of the economy.Journal of Economic LiteratureClassification Numbers: E32, D43.