“A Model of Commitment Strengthening in a Fixed Exchange Rate Regime” by Stephen CHIU
Chinese University of Hong Kong
A government may face currency attacks solely because of the time consistency problem in keeping its currency peg. This paper constructs a theoretical model to examine the desirability/possibility of the government to reduce the devaluation probability through committing to a greater capital loss in case of devaluation. We find that this will not be desirable for governments with low credit lines or with low financial stress costs, and for other cases, very often a rule of the excluded middle occurs: commitment strengthening is beneficial only if the strengthening is large enough. We then consider the proposal (Chan and Chen ,1999; Miller, 1998) whereby structured notes are sold through a market mechanism to allow market participants to insure their local currency holdings. We find that this form is generally more likely to be beneficial. In an incomplete information framework where the type of the government is unknown to the public, however, this form of commitment strengthening is not particularly useful as a signaling device. We find that separating equilibria never exist in which the strong type issues structured notes while the weak type does not. Moreover, unless the government's credibility is sufficiently low, structured notes issuing will not beneficial when the public holds the belief that only the weak type government will issue structured notes. This latter belief is substantiated by the fact that ironically the weak type government needs commitment even more than the strong type does. Having said this, we note that when the government's credibility is sufficiently low, issuing structured notes will become the strong type's equilibrium play despite the weak type's mimicking.