What Drives Currency Revaluation Decisions?

Abstract

My thesis explores the problem of whether countries that chronically resist revaluations are ever vulnerable to speculative attacks the way countries that resist devaluations are. The theoretical model I introduce sheds light on the timing and nature of Switzerland’s unpegging decision on January 15, 2015 and whether they are consistent with a rational, optimizing policy maker. Specifically, the model demonstrates the strategy a forward-looking policy maker would adopt when its currency peg is under speculation. Each period, the policy maker compares the cost of abandoning the peg to that of maintaining it. The economy experiences a short-term output shock after the abandonment of the fixed peg, which captures the output costs imposed by price rigidities when the ex- change rate fluctuates. The model shows that the policy maker is able to avoid predictable speculative attacks by pursuing a randomized strategy in equilibrium. So instead of a sudden speculative attack, there is a prolonged period of increased probability for the policy maker to abandon the peg and increased speculation, which is represented speculators’ accelerated purchase of domestic currency. In the empirics section, I apply my model to Switzerland and Den- mark between 2011 and 2015 and show the correlation between reserve level and market speculation against the peg.