Costs and Coordination of Speculation

Why do speculators seem to wait with their speculative attack on a fixed exchange rate? In this paper we try to answer this question by extending the models of Krugman (1979) and Flood and Garber (1984) on balance of payments crises. We review their two-country model in discrete time, while taking a more explicit look at the incentives of speculators. We argue that their model implies that a fixed exchange rate regime can only survive as long as the fixed rate is equal to the equilibrium exchange rate. Consequently, their model does not explain why a currency can be overvalued before the attack and why in practice the currency is devalued after the attack with profits for speculators as a result. We discuss two potential causes for these stylized facts: costs of speculative trading and coordination problems among speculators. First, we show that speculation costs, for example because a Tobin tax is levied, is able to explain overvaluation and a jump in the exchange rate after the attack, although profits for speculators remain zero. Second, extending the model by adding identical countries enables us to explain the stylized facts, as coordination among speculators becomes important in order for a focal point to emerge. The coordination date - and therefore the degree of overvaluation, the size of the devaluation, and the resulting profits for speculators - is shown to depend on initial beliefs, the number of speculators, and the amount of strategies and financial funds they have.