A Stochastic Model of Self-Fulfilling Crises in Fixed Exchange Rate Systems.

A fixed exchange rate regime can experience a self-fulfilling crisis if a high risk premium leads to high domestic interest rates that depress domestic activity, and thus make it more likely that the government will actually abandon the system. Depending on the parameter configuration, two equilibria might exist. One is characterized by low interest rates and a low (possibly zero) probability that the exchange rate commitment will be abandoned; the other is characterized by high interest rates and a high probability that the exchange rate commitment will be abandoned. An unstable intermediate equilibrium might also exist. An increase in the uncertainty of the shocks hitting the economy reduces the parameter range in which multiple equilibria can arise. Copyright @ 1999 by John Wiley & Sons, Ltd. All rights reserved.