Coordination and Policy Traps / George-Marios Angeletos, Christian Hellwig, Alessandro Pavan.

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Angeletos, George-Marios

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w9767.Publication details: Cambridge, Mass. National Bureau of Economic Research 2003.Description: 1 online resource: illustrations (black and white)Subject(s):

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Abstract: This paper examines the ability of a policy maker to control equilibrium outcomes in an environment where market participants play a coordination game with information heterogeneity. We consider defense policies against speculative currency attacks in a model where speculators observe the fundamentals with idiosyncratic noise. The policy maker is willing to take a costly policy action only for moderate fundamentals. Market participants can use this information to coordinate on di.erent responses to the same policy action, thus resulting in policy traps, where the devaluation outcome and the shape of the optimal policy are dictated by self-fulfilling market expectations. Despite equilibrium multiplicity, robust policy predictions can be made. The probability of devaluation is monotonic in the fundamentals, the policy maker adopts a costly defense measure only for a small region of moderate fundamentals, and this region shrinks as the information in the market becomes precise.

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Previous	nber w9764 Idiosyncratic Production Risk, Growth, and the Business Cycle /	nber w9765 The Quantity and Quality of Life and the Evolution of World Inequality /	nber w9766 International Migration, Remittances, and Schooling: Evidence from El Salvador /	nber w9767 Coordination and Policy Traps /	nber w9768 The Vintage Effect in TFP Growth: An Analysis of the Age Structure of Capital /	nber w9769 The Effect of Welfare Reform on Prenatal Care and Birth Weight /	nber w9770 Historical Perspectives on Racial Differences in Schooling in the United States /	Next

June 2003.

This paper examines the ability of a policy maker to control equilibrium outcomes in an environment where market participants play a coordination game with information heterogeneity. We consider defense policies against speculative currency attacks in a model where speculators observe the fundamentals with idiosyncratic noise. The policy maker is willing to take a costly policy action only for moderate fundamentals. Market participants can use this information to coordinate on di.erent responses to the same policy action, thus resulting in policy traps, where the devaluation outcome and the shape of the optimal policy are dictated by self-fulfilling market expectations. Despite equilibrium multiplicity, robust policy predictions can be made. The probability of devaluation is monotonic in the fundamentals, the policy maker adopts a costly defense measure only for a small region of moderate fundamentals, and this region shrinks as the information in the market becomes precise.