When pegging ties your hands
BIS Working Papers No 547
Could a less conservative central bank - one that faces a more severe time inconsistency problem - be less likely to succumb to an attack on a currency peg? Traditional currency-crisis models provide a firm answer: No. We argue that the answer stems from these models' narrow focus on how a central bank's response to a speculative attack affects output and inflation in the short run. The answer may reverse if we recognize that a credible currency peg solves time consistency issues in the long run. As a less conservative central bank stands to benefit more from tying its own hands, it should find a peg more valuable.
JEL classification: D82, D84, F31
Keywords: currency crises, strategic uncertainty, global games, time inconsistency