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By Dimosthenis Tambakis


Abstract: Do expected future exchange rate fluctuations affect current social welfare? In third-generation currency crisis models, financial fragility can trigger devaluation and default. Expected future depreciation is costly if it raises ex ante real interest rates. Given the strong violation of uncovered interest parity, expected future outcomes ’ current cost/benefit dependson the currency risk premium. I extend the static one-period Barro-Gordon welfare loss function to include expected future depreciation and show that, when foreign investors are risk-averse, the one-period discretionary optimum depends on the specification of the aggregate demand function. If demand depends on the ex post real interest rate then average depreciation can be zero if current welfare is sufficiently sensitive to the state of the financial sector. In this stylised framework, depreciation bias can be mitigated even in the presence of time-inconsistency, and expected welfare may be higher. 0 ∗ I thank Paul Masson for helpful comments. An earlier version benefited from participants’ comments at the 2001 ESEM and EEA meetings (Lausanne). The usual disclaime

Year: 2003
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