Coordination, Cooperation, Contagion and Currency Crises 1

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1 oorato, oorato, otago a urrc rss Olvr Losl * a Phl Mart ** Jauar 999, ths vrso Jauar 000 bstract W aalz th ffct of tra comtto, tratoal coorato a coorato o currc crss. To o ths, w rst a mcro-fou mol whr govrmts hav a ctv to valu to cras th atoal markt shar a mooolstcall comttv sctor. urrc crss grat b slf-fulfllg xctatos ar ossbl bcaus rvat agts ma hgh wags wh th xct a valuato. Ths crass th comttvss a rofts of atoal frms a ucs th govrmt to valu. W show that th mor mortat tra comtto, th mor lkl slf-fulfllg sculatv crss ar a th largr th st of multl qulbra. oorato crass th ossblt of smultaous slf-fulfllg sculatv crss th rgo a rucs th st of multl qulbra. Howvr, rgoal coorato, v though wlfar mrovg, maks coutrs mor t o othr coutrs fuamtals so that t ma uc mor cotago. oorato furthr rucs th st of multl qulbra wth currc crss. Kwors otago, coorato, coorato, fx xchag rats, xchag rat crss, tra comtto JEL umbrs: F4, F4, F33 Ths s a rvs vrso of EPR scusso ar 075. W ar gratful to thr rfrs for thr usful suggstos that l to substatal mrovmts. W also thak ot ouré, Prr-Phl ombs, Olvr Ja, Phl La, Hélè R, Ros, Jacqus Thss a Yvs éou for thr commts. * EPREMP a ERS-ENP, Pars ** ERS-ENP, Pars a EPR, corrsog author arss: ERS-ENP, 8 ru s Sats Pèrs, Pars, Frac. Emal : [email protected] Tl. : Fax :

2 I. Itroucto Rct currc crss, such as th EMS crss, th crash of th Mxca Pso 994 a ts Tqula ffct o othr coutrs as wll as th sa crss hav volv svral coutrs th sam gograhcal rgo. Most rctl, th sa crss brok out Thala Ma 997, but sra ral to Malasa, th Phls, Iosa a South Kora. I th Euroa cas, cotago was also mortat as th crss ht fv coutrs (Fla, th K, Ital, Sw a Norwa) ts frst ar. 993 all coutrs xct Nthrlas ha to w th ba of fluctuato wth th DM. Th attack o th so was tslf follow b attacks o svral Lat mrca coutrs. Dst th fact that currc crss tcall volv svral coutrs that fx thr currcs thr to th ollar or to th DM, xstg mols of currc crss look at th roblm a two coutr framwork whr th actos of th coutr that gs ts currc ar k. Ths s th cas of mols of th frst grato t (Krugma [979]), whr th crss coms wth a ru o th tral ak s rsrvs, bcaus sculators ursta that motar authorts couct a olc cosstt wth th fx art. Ths s also th cas wth sco grato mols (Obstfl [99]), whch cosr valuato as a ttoal cso of a govrmt, that wghs avatags a savatags: th cost of otg out of th fx xchag rat sstm s rmarl cosr as a oltcal cost; as for th cost of stag, t ca b mol as hgh trst rats or as umlomt 3. s argu b Glck a Ros [998], from th rsctv of most sculatv attack mols, t s har to ursta wh currc crss t to b rgoal. Th argu that tra lkags shoul b frst amog th suscts for xlag rgoal cotago of currc crss a gv strog mrcal suort to ths chal usg fv ffrt crss. Echgr, Ros a Wlosz [996], a mrcal stu usg thrt ars of al ata from twt ustralz coutrs, also coclu favor of a strogr xlaator owr of tratoal tra lkags tha of macrocoomc smlarts. Ev though ot mol xlctl b ths authors, th rol of tra lkags s that th rsc of rc rgts a valuato brgs a short trm comttv avatag to th coutr that valus a thrfor crass th cost for tra artrs ot to valu. Th xstc of ths sllovrs rass th ssu of tratoal coorato: f govrmts tak to accout th gatv xtralts of valuato o othr coutrs, t mght b asr to sto th sowball, rhas v bfor t starts. ctuall, som sts ha b tak bfor th outbrak of th sa crss towars cras motar coorato

3 btw East sa coutrs 4. s rohs b aoum a Echgr [996], ths uassumg masurs howvr rov suffct to rl a all-out attack o a sa currc comarabl to th Mxca or ERM crss. I ths ar w aalz th rol of tra lkags currc crss. To o ths, w rst a thr coutr mol that buls o thr sarat ltraturs: ) th ltratur o tratoal motar coorato, scall azor a Hrso [99] s thortcal aroach, ) th ltratur o currc crss, or mor rcsl o th sca claus aroach of fx xchag rat sstms, 3) th mcro-fou w o coom macrocoomcs framwork tat b Obstfl a Rogoff [995] a rvw b La [998]. Our mol corrsos to a thr-lar, squtal gam. Th lars volv ar rvat agts a th two govrmts that ulatrall g thr currc to a thr o. Th two govrmts hav a ctv to valu bcaus coutrs comt o a mooolstcall comttv goo that th both xort. urrc crss that ar grat b slf-fulfllg xctatos ar ossbl bcaus rvat agts ratoall ma hgh wags wh th xct a valuato. Ths crass th comttvss of atoal frms a ucs th govrmt to valu. To our kowlg, ths framwork s th frst attmt to trouc mcro-fouatos mols of valuatos wth slf-fulfllg xctatos. W show that v wh qulbrum valuatos o ot gv a short trm comttv avatag, strog tra comtto crass th lklhoo of currc crss that ar uc b slf-fulfllg xctatos a magf rgoal stablt b crasg th umbr of ossbl multl qulbra. W also show that coutrs that xort goos mooolstc sctors ar mor ro to valuato uc b slf-fulfllg xctatos tha coutrs scalz comttv sctors. W aalz th rol of tratoal coorato a coorato ths cotxt. oorato s f as azor a Hrso [99]: govrmts coorat o th bst Nash qulbrum so that t os ot rqur a commtmt tcholog. Polcmakrs o ot gv u sovrgt ths cas a all that s rqur s that th mt a coorat o a goo o cooratv soluto, for xaml a rgoal forum. caus multl qulbra u to slf-fulfllg xctatos ar a atural outcom ths t of stu, th qusto of th fasblt of coorato o a scfc qulbrum s a atural a mortat o. oorato s mor mag as t mls that govrmts maxmz a jot wlfar fucto. It thrfor rqurs a commtmt tcholog th form of a suraatoal sttuto that forcs th agrmt. oth coorato a coorato cras but o ot lmat th ossblt of smultaous slf-fulfllg sculatv crss a

4 3 ruc stablt b lmtg th st of multl qulbra. Howvr, rgoal coorato, v though wlfar mrovg, maks coutrs mor t o othr coutrs fuamtals so that t ma uc mor cotago: f o coutr of th rgo s mor lkl to valu bcaus of a worsg of ts fuamtals, ths crass th ossblt of a currc crss both coutrs bcaus t rucs th crblt of coorato btw th two coutrs. Our ar s rlat to utr, orstt a Pst [995] a [998] who aalz th bfcal rol of coorato th cotxt of xchag rat crss Euro. It ffrs svral msos. Frst, our mol s bas o mcro-fouatos. Sco, xctatos of th rvat sctor la o rol thr aalss of tratoal coorato so that th currc crss th obta ar ot u to slf-fulfllg xctatos a multl qulbra o ot ars. Fall, bcaus th o ot allow for th ossblt of multl qulbra uc b slf-fulfllg xctatos, th o ot aalz coorato but ol look at th most mag form of coorato whr govrmts mmz a jot loss fucto. othr rlat ar s orstt, Pst, Roub a Tll [998], who rst a mcro bas mol of comttv valuatos. Our mol s ffrt that t aalzs th stratgc tractos that la to ossbl currc crss whras thr ar stus th ffrt wlfar cosqucs of a valuato. I cotrast to thr mol, slf-fulfllg xctatos of rvat agts la a crucal rol our aalss. Fall, bcaus w assum th two coutrs ol tra wth th coutr to whch th fx thr xchag rat, w rstrct ourslvs to th cas wh th sllovrs of a valuato ar gatv. Ths s cotrast to th two ars ct abov as wll as to Obstfl a Rogoff [995] who show that rsc of tra, th sllovrs from a valuato ca b ostv va th trms of tra ffcts. W rst a sml mcro-fou mol of comttv valuatos scto II. W th solv a aalz th ffrt ossbl qulbra of th gam Scto III. Scto IV coclus. II. Th basc framwork Th mol corrsos to a thr-coutr worl: coutr, coutr a coutr. outr rrsts a larg coutr to whch coutrs a hav gg thr currcs. To fx as, w wll call th currc of coutr th ollar. W wll assum that coutr s larg comar to a, s ot affct b thr olc a thrfor os ot act stratgcall. outr las two rols our mol: ) t ssus th umrar currc; ) t

5 4 abls us to ffrtat comtto btw coutrs that fx thr xchag rat to a thr o ( a ) a comtto btw a fxg coutr ( or ) a th coutr to whch t gs ts currc (). s Obstfl a Rogoff ([995] a [996]), w trouc a mooolstcall comttv sctor. outrs a ar both full scalz ffrt varts of ths sctor. I cotrast to Obtfl a Rogoff, ths varts ar ol xort to coutr. Thr ar,, a frms (rsctvl coutrs, a ) whch ach rouc a ffrt vart. caus of th small coutr assumto for a, th worl aggrgat ma for a comost trmat goo ma of th ffrt varts s assum to b xogous a gv b: Y j j / / / / ; N ; > j j j j j j j whr j rrsts th roucto of frm j coutr a s th lastct of substtuto btw th ffrt varts. s th worl ma for th comost goo Y crass, worl tra crass for a gv umbr of frms th worl. Hc, w focus our attto o a vromt whr coutrs a comt o th sam thr markts. Ths s cosstt wth th masur of tra lkag us b Glck a Ros [998] who focus o comtto o thr markts rathr tha o rct blatral tra. Echgr, Ros a Wlosz [996] also ot that Fla s valuato august 99 was wl rgar as havg ha gatv rrcussos for Sw, ot so much bcaus of rct tra btw th two coutrs but bcaus thr xortrs comt o th sam thr markts. I coutrs a, agts (whos umbrs ar rsctvl a ) shar th sam rfrcs: th rv utlt from cosumto of goo x mort from coutr 5 a sutlt from ffort labor masur b l. Th utlt fucto of a rrstatv agt s lar a gv b: ( l ), x γ δ whr γ masurs th rlatv sutlt from ffort. W hav also a a fx cost,,, th cas th govrmt valus. δ 0 f th govrmt cs ot to valu a f th govrmt valus. W trrt ths cost as arsg from th sruto of th coomc actvt cas of valuato. I mols of sculatv attacks (s Obstfl [996], Ja [997]) ths cost s bor b th govrmt that looss crblt th cas of a valuato. I our framwork, w choos to mol ol a scfc sruto cost 6 : th () ()

6 5 valuato, bcaus t mls to chag rcs of mort goos local currc, rqurs agts to s a fx ffort chagg mus a trs th utlt accorgl. Th bugt costrat of a rrstatv agt coutr, s gv b th followg quato: w l t x, (3) Ths bugt costrat s gv trms of th local currc. rrstatv agt rvs com from labor a at wag w coutr a from a govrmt trasfr t whch wll b tal latr. Th mort goo x s a at th omal xchag rat btw coutr a. W ormalz a fx th rc of goo x to o a w assum zro flato that coutr urg th ro. For a cosumr, th cost of th mort goo local currc wll thrfor b thr f th fx xchag rat s mata or f th govrmt cs to valu at th xogous rat 7. Th tmg of csos b th ffrt lars s gv blow. Frst, wags a local currc ar st. Th ca ot b chag aftrwars. Ths s th sourc of rgt th mol whch, togthr wth th assumto that wags ca ot b a ollars, xlas wh valuatos ma b otmall chos. Sco, ach govrmt cs whthr to valu or ot. Thr, mooolstc frms st thr rcs to maxmz rofts. Dmas for xort goos ar th ralz, as wll as mas for mort goos. Fall, roucto a cosumto tak lac. Wags ar fx Govrmt cs o valuato Exort rcs ar st Work, roucto a cosumto tak lac Thr ar two sourcs of ffcc ths st-u. Frst, th goo markt s mooolstc so that roucto wll b too low. Sco, a alcato of oubl margalzato, th labor markt s also mooolstc bcaus thr s a sgl uo r frm. Ths wll ush th wag rat too hgh. Th rc lastct for a sgl roucr of th xort goo s -, so that w gt th usual rc rul (xrss local currc) for a mooolstc roucr who maxmzs rofts: wβ/(-) whr β s th labor rqurmt (commo to all thr coutrs) th xort sctor. W assum that thr s a sgl uo r frm. Th mooolstc uo ach frm kows th rc rul abov a th labor ma fucto wh t cs o th wag. It

7 6 thrfor taks to accout that th wag lastct of roucto a labor s -. Its objctv s to maxmz th xct utlt of th rrstatv workr th uo subjct to th bugt costrat. Ths mas that th uo has to form xctatos o th xchag rat olc. Each uo s small (thr ar as ma uos as frms) so that t os ot tralz th fact that t flucs th xchag rat olc or th trasfr (s blow) wh t chooss omal wags. x shows that th wag rat s th mark-u ovr th margal sutlt from ffort labor: w γ,, (4) whr s th xct xchag rat btw coutr a coutr. W wat th ral wag all stuatos, v out of qulbrum, to b hghr tha th margal sutlt of work. Ths moss a aramtr rstrcto such that th lastct of substtuto s small ough: /(-) > 8. I coutr, th wag rat s trm th sam mar but bcaus w fx th rc of x that coutr to, th wag rat s sml γ/(-). Dg o whthr a valuato s xct or ot th coutrs that fx thr xchag rat to th ollar, th omal wags wll b hgh or low. Hc, th xctato o th xchag rat wll fluc th margal cost of mooolstc frms a thrfor thr rc cso: βγ,, local currc a βγ,, ollars. uxct valuato thrfor crass ths rc. sg th mooolstc rc rul, quato (4), a th fact that all frms a scfc coutr ar smmtrc a fac th sam xchag rat, w gt that th ma a th roucto lvls of rrstatv mooolstc frms ach coutr that gs ts currc to th ollar ar (s ax for a mor tal rvato): Y Y r our rfct forsght assumto ( (5),, ), w ca s alra that full xct valuatos wll hav o ral mact as ths cas, th valuato s xactl comsat b a hghr wag a hghr margal cost. Howvr, suos that rvat agts coutr a xct o valuato ( ), so that omal wags ar

8 7 low, th a surrs valuato ( >), wll cras roucto of mooolstc frms a lowr roucto mooolstc frms. Hc, from that ot of vw, a surrs valuato s a bggar-th-ghbor olc ths mol. Ths quatos llustrat th sllovrs at la th mol. Th c of roucto o th xchag rat olc of ca cras two was: frst, f worl tra Y xas a sco f, th umbr of frms comtg o thr markts, crass. Not also, that wh th rvat sctor coutr xcts a valuato, ( > ), th a olc of o valuato ( ) s costl as atoal roucto crass. Ths xlas wh slf-fulfllg xctatos wll occur ths stu. Th mooolstc rofts of frms ar tax a full rstrbut to th rvat agts th form of a lum-sum trasfr. Gv that th umbr of frms a th umbr of agts ar tcal, th trasfr to th rrstatv agt s th roft of th rrstatv frm: t βγ, ( ), wth gv b quato (5). It s as to chck that rofts of frms a thrfor th rcata trasfr cras wth xchag rat xctatos a cras wth th xchag rat of th coutr. caus ach small uo os ot tralz th mact of ts wag cso o th aggrgat trasfr, omal wags wll b too hgh. Takg to accout ths trasfr th cosumr bugt costrat, th qulbrum utlt of a rrstatv agt s gv b: βγ δγ,, whr s gv b quato (5) a th trm brackt s alwas ostv u to th aramtr rstrcto: /(-) >. O to of th staar valuato cost, ths quato shows that a uxct valuato has two wlfar cosqucs. O th o ha t rucs th urchasg owr of cosumrs b crasg th rc of mort goos: th trm th brackt taks th valu / th cas of a uxct valuato. O th othr ha, as show quatos (5) a (6), t crass omstc roucto, rofts a com. Th roblm of ach govrmt wll b to st th xchag rat to (o valuato) or (valuato), takg xchag rat xctatos a th xchag rat olc of th othr coutr as gv, orr to maxmz th utlt of th rrstatv cosumr. (6) (7)

9 8 Th absc of a o tra local goo mls that th cosumto rc x s th xchag rat a ths smlfs gratl th aalss. If such a goo was trouc, th wag rat woul o th xct rc x that woul comrs both local a mort goos. Hc, a xct valuato woul la to a cras omal wags of lowr magtu. From that ot of vw, slf-fulfllg xctatos woul b lss mortat gratg currc crss. O th othr ha, bcaus th urchasg owr cost of a valuato s lowr th rsc of local goos, ths shoul la to a strogr ctv to valu. III. Ratoall xct Nash qulbra caus w assum that coutr os ot la stratgcall vs-à-vs coutrs a, th rlvat lars ar th followg: uos, th govrmt of coutr a th govrmt of coutr. Thr ar two gams: th frst o taks lac btw th rvat sctor o th o ha a th govrmts o th othr ha, a th sco o btw th two govrmts. caus uos, wh th form xctatos o a valuato, bas thm o th xct rsult of th gam btw th govrmts, w solv th gam b backwar ucto. W wll frst aalz th qulbrum of th gam btw th govrmts bfor lookg at th rvat sctor s xctatos. Th qulbrum ths gam s o th sttutoal sttg that govrs th rlatos btw th govrmts of a, whch w assum s kow b th rvat sctor wh t sts ts xctatos: o coorato: govrmts la Nash; a Nash qulbrum s such that o govrmt has a ulatral ctv to vat. If, th olc gam, svral qulbra ar ossbl, govrmts choos th o xct b rvat agts. coorato: govrmts coorat o th Nash qulbrum that Parto-omats all Nash qulbra. W aot hr th trmolog of azro & Hrso [99] (.4): coorato rfrs to th wa olcmakrs sttl o o soluto out of svral a ocooratv gam. It corrsos to a rlatvl wak rqurmt: wh th govrmts coorat wth ach othr, th o ot to trust ach othr, th just to cosult wth ach othr to smultaousl mov to a scfc Nash qulbrum. Oc th coorat o a outcom, o of thm has a ctv thr to vat ulatrall from t or to vat a coorat mar from t. Ths stablt maks coorato crbl to rvat agts.

10 9 coorato: th govrmts choos th outcom that maxmzs th sum of th utlt lvls of rrstatv cosumrs. oorato moss solart btw both govrmts. Sc t ma la to outcoms whch rov ot ulatrall stabl, bcaus th ar ot Nash qulbra, coorato ma ot aar crbl to rvat agts. W wll thrfor cosr cooratv qulbra as bchmark qulbra. W wll to assum thr crblt, through a commtmt tcholog that ma volv som sttutoal structur for stac. W assum that uos kow th atur of th gam govrmts la: o coorato, coorato or coorato. W assum morovr that uos a govrmts hav full formato o all aramtr valus. Sc o ucrtat xsts, ratoal xctatos qulbra corrso to rfct forsght qulbra. III.. No coorato Suos that rvat agts xct o of th govrmts to valu:. Govrmts th la ths scfc gam. If aramtrs ar such that thr or has a ctv to vat, th s a ratoall xct Nash qulbrum. Ths wll b th cas wh: ) ; ( ) ( ) ; ( ) ( a Ratoal rvat agts ma xct wh ths two qualts ar satsf: th corrso to a. Ths thrshol valus for th costs of valuato ar gv ax 3. I agram, th qulbra hav b llustrat rlato to th valu of aramtrs. Now, suos that rvat agts xct both govrmts to valu:. Th govrmts, th olc stag, th la a ffrt gam. If aramtrs ar such that: ) ; ( ) ( ) ; ( ) ( a th s a ratoall xct Nash qulbrum. ccorgl, agram, ths qulbrum xsts for aramtrs such that a. Hc, th ossblt of

11 0 multl qulbra arss th ml rctagl of agram. Th xstc of asmmtrc qulbra,, a, s chck through a smlar stratg. Dagram 9 Th gam s qulbra, wh th govrmts o ot coorat wth ach othr W ca show aaltcall that > a > wh 0, 0 a wh s suffctl small (s ax 4). Numrcal smulatos ot la to a xaml whr ths woul ot b th cas for hgh valus of, as log as ostv. > > a ar Th ara of maxmum stablt s gv th ml squar whr all qulbra ar ossbl u to slf-fulfllg xctatos. Th tuto for th ossblt of slf-fulfllg xctatos a valuato wh govrmts o ot coorat shoul b clar b ow. If agts coutr xct a valuato, th th ask for hgh omal wags. I ths cas, f th govrmt os ot valu, mooolstc frms of th coutr loos comttvss a com crass. If th fx cost of valuato s ot too hgh (blow th thrshol,, ), th valuato s a qulbrum. Wh th cost of valuato s vr low both coutrs (blow th thrshol,, ), th th ol qulbrum s that both coutrs valu smultaousl. Ths s bcaus ths cas, th tmtato to gag comttv valuato (v f rvat agts ot xct such a valuato) s vr hgh. Ths qulbrum woul b lmat f th labor markt was rfctl comttv.

12 W ca aals th ffct of th comttv structur of th ustr b lookg at th mact of a cras th worl umbr of frms N th ustr o th thrshol valus agram. To smlf th xrcs w look at th ffct of a cras of N o th thrshol valus th cas whr /3 N so as to k th rlatv lvl of. comtto btw coutrs smmtrc. It s as to chck th that: < 0; < 0 N N Hc, coutrs scalz mor comttv ustrs (hghr N mls mor comtto a lss rofts), ar lss subjct to sculatv valuatos. It s also as to chck that th ara of maxmum stablt (all four ossbl qulbra) crass wth N, our masur of th gr of comtto th ustr. Th raso for ths rsults s that as N rss, th ottal roft ga of a uxct valuato crass. Ths s rcogz b rvat agts who ajust thr xctatos accorgl. I th sam v, wh th lastct of substtuto ts to ft, th goos markt bcoms rfctl comttv, a,,, ts to zro so that govrmts vr valu. Ths fts qut wll wth th obsrvato that th attacks hav b mostl coctrat o w ustralz coutrs. No ustralz coutrs such as frca coutrs of th F zo that xort mostl raw roucts hav ha lttl xrc wth attacks o thr fx xchag rat. Othr mortat rasos xst howvr: for xaml, coutrs xortg mostl raw matrals also tcall hav lss o catal markts. Not that tra sllovrs hav a mortat mact o th ossblt of valuatos a of slf-fulfllg xctatos. cras th worl ma a tra of th comost goo Y crass both thrshol valus for both coutrs. Ths mls that th st of aramtrs for whch both coutrs valu smultaousl xas, a that th st of aramtrs for whch o coutr valus arrows. Not also that as Y crass, th ffrc btw a,,, crass so that th ml squar of maxmum stablt wth slf-fulfllg xctatos xas. Ev though qulbrum valuatos hav o ral mact bcaus th ar full xct gv our rfct forsght assumto, thr ottal mact out of qulbrum xlas th cras ctv to valu (a thrfor th cras ossblt of slf-fulfllg xct valuatos) wh tra crass. Wth mor tra, th ottal ga of a uxct ulatral valuato s hghr as utlt crass wth rofts that thmslvs cras wth roucto a xorts 0. caus ths ottal ga s full xct b rvat agts, tra magfs th ossblt of valuatos uc b slf-fulfllg xctatos.

13 Evaluat at /3 N a holg N a costat, w ca also show that: > 0; > 0 wth smmtrc rsults for th thrshol lvls coutr. hghr umbr of comttors crass th ctv of coutr to valu a xas th st of multl qulbra wth all four qulbra. Th tuto s that a hghr umbr of comttors crass th mortac of tra sllovrs for. O ca also chck that wh a ar suffctl small comar to, bcoms gatv so that os ot valu whatvr os. I ths cas, tra sllovrs ar small th ss that coutr os ot comt much wth coutr o thr markts. Ths also sas that larg coutrs ar lss ro to currc crss tha small os. III.. oorato caus valuatos qulbrum hav o ral ffct o outut as th ar full xct a bcaus of th fx cost of valuato, th qulbrum whr o govrmt valus alwas Parto-omats th qulbrum whr o or both govrmts valu. Hc, th cas of multl qulbra, coorato o th Nash qulbrum wth o valuato ca mrov wlfar. W wat hr to trm ur whch crcumstacs such a coorato s fasbl. Suos that rvat agts xct both govrmts to valu:. If aramtrs ar such that a valu s a Nash qulbrum. Howvr, f: a ( ( ; ; ) ) ( ( th th qulbrum whr both govrmts ; ; ; ; ) ) th v f agts xct both coutrs to valu, govrmts coul, for ths st of aramtrs, coorat o th Nash qulbrum whr th jotl c ot to valu. I ths cas, govrmts wll choos to coorat o ths qulbrum bcaus t ca b chck that t Parto omats th o wth smultaous valuato. No of th govrmts has a ctv to o so ulatrall though a ths s th raso wh coorato s rqur. Th coorat qulbrum wth o valuato s crbl th ss that o coutr has a ctv to valu, thr ulatrall or jotl.

14 3 Th two abov qualts corrso to a coor coor, wth a coor coor f ax 3. Thrfor, wh coor a coor, th govrmts coorat o chagg thr stratgs a thus la rathr tha. gts accorgl chag thr xctatos. Stuatos whch agts o ot xct smultaous valuatos la to rsults smlar to th o coorato cas. ll ossbl qulbra ar llustrat o agram. Dagram Th gam s qulbra, wh th govrmts coorat wth ach othr. - coor coor s show agram, coorato rucs but os ot lmat th st of aramtrs whr slf-fulfllg xctatos of valuatos both coutrs ar qulbra. Howvr, t os ot ruc th st of aramtrs for whch a valuato o coutr ol s a qulbrum so that ts mact s ol stuatos wh rvat agts xct both coutrs to valu. Tra comtto btw th two coutrs xlas th ossbl ffrc btw coorato a o coorato. If for xaml coutr os ot comt wth coutr ( 0), th t s as to chck that uslss. coor so that coorato wth s Not that coorato, whos rol s to lmat th wors ossbl qulbrum, s fasbl a usful scall wh coutrs ar suffctl smlar a wh th

15 4 valuato cost both coutrs s suffctl hgh rlatv to th ottal valuato ga. Othrws, th qulbrum whr o coutr valus caot b a Nash qulbrum wh agts xct both coutrs to valu as o coutr at last wll hav a ctv to vat a valu. I ths cas, coorato o th o valuato qulbrum s ot sustaabl. I othr wors, a aoucmt b both govrmts that th wll ot valu wh omal wags ar hgh s o logr crbl. Ths also llustrats a cha l of cotago of currc crss ffrt of thos usuall tf. I agram, t ca b chck that f bcoms lss tha coor (thr bcaus crass or bcaus coor crass), th th ossblt of a slf-fulfllg currc crss crass ot ol coutr but also coutr : wh coor crass, th ara of qulbra (--) s ruc at th xs of th ara of qulbra (--). Ths chag th coomc stuato of coutr maks coorato btw th two coutrs mor ffcult to susta a a aoucmt that govrmts coorat o th o-valuato qulbrum wll ot b crbl ths ss. If rvat agts ow xct both coutrs to valu, th coorat qulbrum whr both coutrs c ot to valu s o logr a Nash qulbrum. outr wll b uc to vat a valu. Ths tslf ucs coutr to valu. Ths chal of cotago s ffrt from th classc o. Hr, cotago of th currc crss coms from th fact that rgoal coorato bcoms lss crbl th s of rvat agts wh fuamtals o coutr ar such that ths coutr s mor lkl to suffr a currc crss. It llustrats th ambguous ffct that coorato has o th ssu of rgoal cotago. omar to o coorato, t rucs th ossblt of smultaous sculatv crss a rgo wth mortat tra sllovrs a ths ss s wlfar mrovg. Howvr, bcaus th crblt of coorato tslf s t o aramtrs of both coutrs, t troucs a w chal of cotago. III.3. oorato oorato btw two coutrs of ffrt sz s ffcult to aalz so w choos to rstrct our attto to th cas whr th two coutrs ar tcal: a 3. s utr, orstt a Pst [995, 998] w assum a atoal horzotal qut costrat, accorg to whch o tratoal agrmt s forcabl ulss coutrs that ar tcal x at u havg a tcal lvl of wlfar x ost. Ths xclus th ossblt of a cooratv qulbrum whr o coutr valus a th

16 5 othr os ot. oorato th mls that govrmts choos jotl th sam xchag rat olc that maxmzs th utlt of a commo rrstatv cosumr. I ffct, coorato s tcal to th cas whr th two coutrs form a motar uo. Suos that rvat agts xct th govrmts to coorat o th o- valuato qulbrum:. If aramtrs ar such that: ( ( ; ) ) ( ( ; ) ) th s a ratoall xct cooratv qulbrum. Suos o th cotrar that rvat agts xct govrmts to coorat o th valuato qulbrum. If aramtrs ar such that: ( ( ; ) ) ( ( ; ) ) th s a ratoall xct cooratv qulbrum. Th frst qualt corrsos to valus of coo a coo. Th sco qualt corrsos to coo ar gv ax 3. coo. Th Dagram 3 shows that v though a valuato has o ral mact qulbrum, coorato btw a s ot ough to lmat th ossblt of slf-fulfllg currc crss. Th raso s that, v though govrmts ca commt to ach othr th stll ca ot commt to rvat agts. Out of qulbrum, th ca coorat a surrs rvat agts through a valuato a ga comttvss rlatv to coutr frms. Th qulbrum wth valuato s full lmat ol wh 0. I ths cas, gatv bcaus govrmts a hav o ctv to valu. coo s Dagram 3: Th gam qulbra wh govrmts coorat 4 - coo coo coor It ca b chck that for, coo > a that coo >. Ths mls that coorato arrows th st of aramtrs for whch both coutrs valu a xas

17 6 th st of aramtrs for whch both coutrs c ot to valu. caus coo s lowr tha coor coor coor (wth ), coorato rucs th st of aramtrs for whch both coutrs ma valu a mrovs wlfar rlatv to th coorato qulbrum. It s as to s that wh tra sllovrs ar lmat for ( ts to zro), th coo a coo coor so that coorato btw a s uslss. otrar to coorato, coorato rqurs a strog commtmt tcholog to b sustaabl so that w vw t mal as a bchmark cas. Howvr, f w trrt th Euroa tgrato rocss a th oltcal sttuto bulg that gos wth t as such a commtmt vc, w ca aalz th mact of Euroa motar coorato o cotago ths scfc cotxt. IV. ocluso I ths ar, w hav ask two sts of qustos. Frst, how o rgoal tra structurs fluc th stablt of a fx xchag rat rgm a th robablt that t collass smultaousl th rgo? Th aswr to ths qusto s that th mor tra comtto btw coutrs a mooolstc sctor, th mor fragl fx xchag rat rgms ar. W hav show that ths s th cas v a mol whr thr s o ral ga to a valuato qulbrum bcaus th valuato s rfctl xct b agts. Th rsult s lkl to b v strogr f w allow for th ossblt of uxct shocks that woul la to uxct valuatos. Sco, o coorato a coorato ruc stablt a cotago? W hav show that th aswr to ths sco qusto s mor ambguous. Nthr coorato or coorato at th rgoal bass, lmat th ossblt of crss uc b slf-fulfllg xctatos. Howvr, coorato a coorato ruc th st of fuamtal aramtrs for whch smultaous valuatos s a qulbrum a ar thrfor wlfar mrovg. oth ar stablzg th ss that th ruc th umbr of qulbra. caus multl qulbra u to slf-fulfllg xctatos ar a atural outcom of ths t of mol, th rol of coorato o a scfc qulbrum s mortat. I cotrast to coorato, coorato os ot rqur a commtmt tcholog, a shoul thrfor b rlatvl as. W hav show howvr that coorato rucs th ossblt of smultaous valuatos, at th cost of makg ach coutr s mor t o th othr s fuamtals.

18 7 Rfrcs aoum T. a. Echgr [996]: Is sa a Otmum urrc ra? a t bcom o? Rgoal, Global a Hstorcal Prsctvs o sa Motar Rlatos, ar rst at th EPII/ME/KDI cofrc o xchag rat arragmts for East sa coutrs, 4-6 Novmbr 996, Soul. sa. a O. Ja [997]: Th Istablt of Fx Exchag Rat Sstms wh Rasg th Nomal Itrst Rat s ostl, Euroa Ecoomc Rvw, ugust, vol. 4, 8, utr W., G. orstt a P. Pst [995]: tr-prhr Mol of Motar oorato a Exchag Rat rss, EPR Dscusso Par No [998]: Facal Markts a Euroa Motar oorato, ambrg vrst Prss. azro M. a D. Hrso [99]: Motar Polc Itrt Ecooms, a Gam-Thortc roach, MIT Prss. orstt G., P. Pst, N. Roub a. Tll [998]: omttv Dvaluatos: a Wlfar- as roach, NER workg ar o. 6889; Joural of Itratoal Ecoomcs, forthcomg. Draz. a P. Masso [994]: rblt of Polcs vrsus rblt of Polcmakrs, Quartrl Joural of Ecoomcs, 09, Echgr.,. Ros a. Wlosz [996]: otagous urrc rss, EPR Dscusso Par No Frasr. [995]: tral ak o-orato th sa Rgo, uublsh mauscrt, Rsrv ak of ustrala. Grlach S. a F. Smts [994]: otagous Sculatv ttacks, EPR Dscusso Par o Glck R. a. Ros [998]: otago a Tra: Wh r urrc rss rgoal, EPR Dscusso Par 947. Ja O. [995]: Mols of urrc rss: Ttatv Sthss, wth Scal Rfrc to th EMS rss, Mmo [997]: r urrc rss Slf-fulfllg? Tst, Joural of Itratoal Ecoomcs, vol. 43, 3 /4, Krugma P. [979]: Mol of alac-of-pamts rss, Joural of Mo, rt a akg, La P. [998]: Th Nw O Ecoom Macrocoomcs: Surv, EPR Dscusso Par 5. Losl O. a P. Mart [999]: oorato, oorato, otago a urrc rss, EPR Dscusso Par N 075. Masso P. [998]: otago: Mosooal Effcts, Sllovrs a Jums tw Multl Equlbra, IMF workg ar 4. Obstfl M. [99]: Dstablzg Effcts of Exchag Rat Esca lauss, Workg Par No 3603 (NER, ambrg, M) [996]: Mols of urrc rss wth Slf-Fulfllg Faturs, Euroa Ecoomc Rvw 40, Obstfl M. a K. Rogoff [995]: Exchag Rat Damcs Rux, Joural of Poltcal Ecoom, 03, [996]: Fouatos of Itratoal Macrocoomcs, MIT Prss, ambrg Mass. Ozka F.G. a. Suthrla [994]: Mol of ERM rss, EPR DP 879.

19 8 x : Wag trmato Th rrstatv mooolstc uo coutr, chooss th wag rat w to maxmz xct utlt: t l w l δ γ takg to accout th followg rcv lastcts: w w l l - ; Equato (4) th txt follows. x : Drvato of ma lvls for ach vart of th comost goo W solv a staar roblm of cost mmzato ur th costrat of total ma. Ths costrat s gv b quato (), whch ca b wrtt trms of th roucto lvls of rrstatv frms: [ ] / / / / Y Domat ollar, th total cost s: Ths las to th followg ma lvl of a rrstatv vart rouc coutr : Y sg th rc formula as a fucto of xctatos of th xchag rat, w gt quato (5) th txt. Th ma lvls for varts rouc ar rv smlarl. x 3: Valus for th ffrt thrshol lvls of th cost of valuato [ ] β N Y [ ] β N Y [ ] β N Y

20 9 [ ] β N Y [ ] [ ] β Y coor [ ] [ ] β Y coor [ ] β N Y coo [ ] β N Y coo x 4: Drvato of cotos ur whch 0 coor. osr, coor a as fuctos of aramtr : ( ), ( ) coor a ( ). It ca b chck that: ( ) ( ) ( ) coor 0, a ( ) ( ) ( ) ( ) ( )( ) [ ] coor Y N β. Ths quatos ml that ( ) s ostv th ghborhoo of f a ol f. It ca b also chck that : ( ) ( ) ( ) ( ) ( ) ( )( ) ( ) [ coor YN 4 β ( ) ( ) ( ) ( ) ( ) ( )( ) [ ] coor N Y 3 3 β. Th frst xrsso rovs ostv wh, that s, wh ( ) s ostv th ghborhoo of. Th sco xrsso rovs ostv f a ol f

21 0 ( ) ( ) 3 3. W kow that: ( ) ( ) 3 3, as. Hc, f ( ) ( ) 3 3 ( ) ( ) 3 3 coor otos ur whch 0 coor, th ( ) ( ) ( ). Ths mls that wh coor a for suffctl clos to o, th 0 ar smmtrc.. coor Dagram o th ffcts of coorato corrsos to 0 a coor It s thrfor val for ( ) ( ) a ( ) ( ) 3 3. Exctos ar Grlach a Smts [994], Masso [998] a utr, orstt a Pst [995] a [998] S for xaml Obstfl [994] or Ozka a Suthrla [994]. 3 S for xaml sa a Ja [994] or Draz a Masso [994]. For mrcal vc o th rol of slf-fulfllg sculato currc crss, s Ja [997]. 4 W ar rfrrg to: Novmbr 995 rurchas agrmts btw th Hog Kog Motar uthort a th ctral baks of ustrala, Malasa, Iosa a Thala. Ths agrmts, b allowg th ctral baks to borrow ollars from o aothr, abl thm to trv mor havl at short otc. Fbruar 996 suort of th ollar/ rat b Hog Kog a Sgaor. March 996 cso of th ak of Jaa, aftr that of Sgaor a th Phls ctral baks, to sg th rurchas agrmts. ss, Frasr [995] ma b ra as a suggsto to go furthr, u to a commo g. 5 Our small coutr assumto o a mls that w srgar a mact of th ma of ths coutrs for x o ts rc. Ths gratl facltats th aalss. 6 W o ot ths fx cost to gt valuatos uc b slf-fulfllg xctatos a multl qulbra. Howvr, u to rfct forsght, t s cssar so that th qulbrum wthout valuato s rfrr to th qulbrum wth valuato. 7 I th workg ar vrso of ths artcl, w aalz th cas of ogous valuato rat a smlr mol. 8 Ths qualt corrsos to w/ > γ th cas whr a. 9 To sav sac, w ot th qulbrum whr both coutrs sta th fx xchag rat, th qulbrum whr coutr valus a os ot, tc. 0 I ato to ths ffct, a hghr lvl of worl tra Y ucs a cras atoal com. Our assumto of lar utlt cosumto mls that ths cras com os ot msh th ctv to valu bcaus th margal bft of a valuato s th sam goo a ba tms. W focus o th cas whr ths qualts ar fulfll. Th cotos ar gv ax 4. r th sam cotos as agram, w hav that. coor > a smlarl for coutr

22 3 Th workg ar vrso of ths artcl full aalzs th cas of coorato. Th coclusos ar ot vr ffrt from thos rst hr. 4 Dagram 3 ca b trrt as a collas vrso of agram whch th coutrs ar smmtrc, th a qulbra ar xclu b coorato, a all cooratv qulbra l alog a 45 l through th org. r th sam cotos as agram (wth ), w coo hav < coo.