This paper analyzes the crucial role of imperfect credibility in a currency crisis with a stochastic dynamic rational expectations regime switch model. The exchange regime is sound, e.g., a currency board-the only market failure is that the Central Bank cannot make a credible commitment to maintain the regime. The model in the paper is stylized, but the results are rich. Investors fear devaluation and the Bank cannot make a credible commitment to allay their fears.
Investors demand an agency currency premium.
The Bank abandons the regime when the expected present value of the agency cost of capital outweighs the expected present value of the benefit from remaining in the regime. The model generates multiple rational expectations equilibria and a variety of patterns linking the exchange rate to the interest rate differential. I parameterized the model using estimates of the exchange rate process for Hong Kong. The model generated interest rate differentials are consistent with the interest differentials in Hong Kong before the Asian financial crisis in July of 1997. We hope that cures most problems.