Learning, Large Deviations, and Recurrent Currency Crises

This article studies a version of Obstfeld's (Journal of International Economics 43 (1997), 61-77) "escape clause" model. The model is calibrated to produce three rational expectations equilibria. Two of these equilibria are E-stable and one is unstable. Dynamics are introduced by assuming that agents must learn about the government's decision rule. It is assumed they do this using a stochastic approximation algorithm. It turns out that as a certain parameter describing the sensitivity of beliefs to new information gets small, the algorithm converges to a small noise diffusion process. The dynamics of exchange rate changes are then characterized using large deviation techniques from Freidlin and Wentzell (Random Perturbations of Dynamical Systems, Second Edition, Berlin: Springer-Verlag, 1998). These methods describe the sense in which the limiting distribution of exchange rate changes is approximated by a two-state Markov-Switching process, where the two states correspond to the two E-stable equilibria. The model is calibrated to the exchange rate histories of Argentina, Brazil, and Mexico. Currency crises in these countries resemble the predicted "escape routes" of the model. A key feature of these escape routes is that expectations of a devaluation erupt suddenly, without large contemporaneous shocks. This is consistent with evidence showing that crises are often poorly anticipated by financial markets