Imperfect common knowledge in first generation models of currency crises

Publication Date
Financial Markets Group Discussion Papers DP 555
Publication Authors

First generation models assume that the level of reserves of a Central Bank in a fixed exchange rate regime is common knowledge among consumers, and therefore the timing of the attack on the currency, in an economy with persistent deficit, can be correctly anticipated. In these models, the collapse of the peg leads to no discrete change in the exchange rate. We relax the assumption of perfect information and introduce uncertainty about the willingness of a Central Bank to defend the peg. In this new setting, there is a unique equilibrium at which the fixed exchange rate is abandoned. In our model, the lack of common knowledge will lead to a discrete devaluation of the local currency once the peg finally collapses.