Devaluation of fixed exchange rates: Optimal strategy in the presence of speculation (Q1571050)

This paper analysis the optimal foreign exchange rate policy of a central bank that is committed to a regime of fixed exchange rate in an inflationary environment. The aim of the central bank is to minimize deviation from a target real exchange rate while maintaining a fixed exchange rate regime. However, the presence of inflation implies that the real exchange rate is eroded over time forcing an eventual realignment/devaluation of the currency. Since speculators are aware of the eventual need for realignment, they will try to size the central bank's reserves of foreign exchange by predicting the timing of devaluation. This paper shows that the optimal response of the central bank to this threat is to abandon deterministic strategies of devaluation in favor of a mixed strategy that makes the probability of devaluation a decreasing function of time. The amount of the potential devaluation and the probability of arrival depend on the cost of devaluation to the central bank, the cost of deviation from the target exchange rate and the strength of capital controls. It is shown that the central bank may want to implement a strategy that calls for a small devaluation immediately after a large one.