How exchange rate attacks work

Exchange rate attacks, when traders attack a currency with a fixed exchange rate, are an interesting game theory example. Countries used fixed exchange rates to give stability and encourage trade with the larger country who’s currency they have fixed their currency to. Normally a currency will fluctuate depending on the economic success of the country, with a fixed exchange rate this cannot happen so there is a risk that the fixed rate ends up a significant distance away from where it should be.

There is a cost to keeping the fixed rate as the economy won’t perform as well as it might with a floating rate, but there is also a cost to revaluing. Whilst the currency’s true rate is close to the fixed rate then the cost of revaluing is higher than the cost to the economy of a less efficient rate. When it moves further away then the cost to the economy goes up and when it exceeds the cost of revaluing then the country should adjust the fixed exchange rate.

Traders can attack the currency to try to force a devaluation. They do this by selling short, i.e. they borrow the currency, sell it and then when they have to pay back their borrowing they buy it again. They hope that in this time the price will have fallen and they will be able to buy it more cheaply to pay off the debt and therefore make a profit.

When the attack takes place there is an increase in the supply of the currency on the market which the country’s central bank has to absorb through buying up the currency. The cost of defending the currency increases the cost to the economy of having the fixed rate, if the cost is pushed above the cost of revaluing then the country will be better off revaluing and the attack will be successful.

To reduce the chance of an attack being successful the country can increase the cost of transactions so that it is more expensive for traders to try to attack or they can introduce capital restrictions to limit the capacity of traders to launch an attack. These can only go so far and any country with a fixed exchange rate and a weak economy will be vulnerable to attack.

As this is a co-ordination game it is interesting to think about whether the central bank making a public announcement about its intentions may actually encourage a co-ordinated attack. I will look at this on Thursday.

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