AN OPTIMAL COMMITMENT MODEL OF EXCHANGE RATE STABILIZATION

Abstract

Recently East Asian countries that have amassed large US dollar reserves face a growing threat of big losses from a sudden decline in the dollar. This threat evokes an issue of the optimal commitment of exchange rate stabilization once raised by Isard (1995) who interpreted the cost of breaking the parity as the capital gain awarded to speculators, in the event the domestic currency is devalued. The only difference in this paper is revaluation. This paper models the central bank’s optimal commitment to exchange rate stabilization when it faces pressure of exchange rate revaluation which may well describe the current episode in East Asian countries. Using a simple equilibrium model optimizing speculators, market maker and the central bank are explicitly introduced and the market maker’s hedging activity is highlighted. The paper considers two equilibria, classic market intervention and market intervention combined with direct regulation on the market maker’s position, the latter of which believes to be commonly exercised by some East Asian governments. The paper shows that the direct regulation may incur larger expected loss on the central bank’s reserves although it leaves the central bank’s interest rate policy more room to maneuver.