Currency Crisis and Multiple Equilibria: The Role of Co-ordination Failures among Heterogeneous Investors

Abstract

International capital markets are inherently unstable, and may precipitate an unnecessary currency crisis as a result of a failure by differentiated investors to coordinate their actions in response to a “mild” fundamental shock. This paper illustrates the point in a simple 3-period model, in which two heterogeneous risk-averse representative investors enter the market at different stages, and a policy-maker who, having to adjust to a current account shock, faces the decision whether or not to devalue the currency. A range of values for the shock is identified over which two equilibria, both rational, coexist. In the “good” equilibrium absence of capital flight and ongoing lending allow an orderly adjustment (no regime switch); in the “bad” one capital flight and the drying up of fresh inflows force the policy-maker to devalue. The short-term nature of capital flows is seen as a crucial determinant of such instability, and the availability of an international lender of last resort is shown to eliminate it.