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A Theory of Speculative Bubbles and Overshooting During Currency Crises Antonio Doblas-Madrid* Michigan State University 110 Marshall-Adams Hall East Lansing, MI 48823 Phone: (517) 355 7755 Fax: (517) 432 1068 Email: [email protected] Abstract ________________________________________________________________________ In this paper, I propose bubbles à la Abreu and Brunnermeier (2003) as a theory that might explain some recent cases of exchange rate overshooting during currency crises. In my model, after a peg collapses, the domestic currency depreciates quickly. Bubbles arise because rational investors keep bidding up foreign currency even after learning that it is no longer undervalued. The exchange rate overshoots until the bubble bursts and the domestic currency regains some ground. The model has two main implications for currency crisis theory. First, self-fulfilling crises become more likely. Second, high interest rates can reduce, or even eliminate, bubbles. ________________________________________________________________________ Keywords: Currency Crises, Overshooting, Bubbles JEL Codes: F31, F32, G12 * I would like to thank Timothy Kehoe, Patrick Kehoe, Juan Rubio-Ramirez, Leonardo Auernheimer, and participants at various seminars and conferences for helpful comments. All remaining errors are my own.1 1. Introduction During several recent currency crises, there was substantial exchange rate overshooting. As Figure 1 illustrates, in Belgium, Denmark, France and Ireland after the widening of ERM bands in August 1993, Korea and Thailand in 1997/1998, and Brazil in 1999, there was a period of fast depreciation, after which the currencies quickly regained a large fraction—in some instances, all—of the lost ground before stabilizing. [Insert Figure 1 here] In some episodes of overshooting, fundamentals plausibly explain the behavior of the exchange rate. For example, the Korean won lost over half of its value vis-à-vis the US dollar between October 1997 and January 1998 and begun recovering on January 28, 1998, exactly when, as reported by Blustein (2001), international bankers and Korean officials reached an agreement to roll over short-term debt owed by Korean banks. This reduced the severity of Korea’s banking crisis, making it less likely that Korean authorities would resort to seignorage-financed bailouts. Within a couple of months, the won regained over half of the value lost in 1997, and stabilized. Brazil in 1999 is another overshooting case where fundamental events—again, narrated in detail in Blustein (2001)—easily explain the currency’s recovery. Following sharp depreciation, the réal began recovering on March 4, coinciding with the arrival of a new central bank president, a bold interest rate hike, fiscal tightening and agreements with the IMF and private creditors. In other overshooting episodes, however, the timing of fundamental events and the timing of the currency’s recovery do not match. One such episode, also chronicled in detail by Blustein (2001), is Thailand in 1997/1998, which abandoned its peg (at roughly2 25 baht/dollar) on July 2, 1997. While Thailand’s first IMF program began in August 1997, the fundamental outlook did not really improve until November of that same year. A new government took office on November 9, 2007, the IMF approved a second program on November 25, and further loan disbursements were extended on December 8 as a reward for the new government’s implementation of tough financial-sector reforms. (For Mr. Camdessus’ exact statement, see IMF External Relations Department News Brief No. 97/29). But the price of a dollar continued skyrocketing from 41.5 baht on December 8 to 55.8 baht on January 12, 1998. At that point, in the absence of any important news about fundamentals, the baht began a quick recovery, reaching 37.8 baht/dollar by March 27, 1998 and ending the year at 36.3. Another crisis, described in detail by Buiter, Corsetti and Pesenti (1998), in which recovery is difficult to explain based on fundamentals is the widening of ERM bands in August 1993. The Belgian and French francs, Danish krona, and Irish punt quickly lost between 4 and 7 percent against the German mark.1 Then, in the absence of important fundamental news, these currencies reversed course and regained most or all of the lost value by the end of the year.2 Motivated by these latter overshooting episodes, I propose a theory of bubbles in the foreign exchange market. Bubbles have traditionally been difficult to reconcile with standard economic theory, as they are often ruled out by backward induction.3 Given a finite bursting time T, investors would sell at 1T−, causing the bubble to burst at 1.T− But then, investors would sell at 2,T− and so on. Iterating, one concludes that prices 1 In fact, France, Belgium/Luxembourg and Ireland joined the euro in 1999, with exchange rates vis-à-vis the German mark at the central parities of the narrow bands before August 1993. And the krona is currently pegged to the euro at the same central parity as before August 1993, with narrow 2.25%± bands. 2 It shall be noted that four percent per month (week) corresponds to over 56 (700) percent per annum. Unless interest rates are very high, investors can make large profits if they anticipate this movement. 3 Tirole (1982) and Santos and Woodford (1997) show that, in a wide variety of environments, bubbles are either fragile or inconsistent with equilibrium.3 cannot deviate from fundamentals. Nevertheless, a series of recent, seminal papers have made great progress modeling bubbles in ways that are increasingly compatible with standard theory and that are immune to this backward-induction argument.4 In particular, I will base my theory of bubbles on Abreu and Brunnermeier (2003) (AB henceforth). Roughly, the key idea in AB is that of a greater fool’s bubble, by which it is optimal to invest in an overvalued asset, as long as there is a good chance of finding a greater fool who will pay even more later. Private information is crucial. Investors have different beliefs regarding when the crash will be, and do not know whether they expect the bubble to burst before or after others do. Investors understand that they will make profits if they sell before the crash and suffer losses if they end up being the greater fool, unable to unwind their position on time. Despite this risk, if probabilities and payoffs are such that expected profit is


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