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Financial markets are typically characterized by a large amount of risk and uncertainty on the part of the market participants, not only concerning the un-derlying fundamental values but also about the behavior of the other market participants. The basic currency crisis models of the first and second gen-eration, however, completely neglected these issues. Rather, first-generation models assumed agents to have perfect foresight about the future develop-ment of fundamentals, and second-generation models additionally presumed speculators to have common knowledge of their opponents’ behavior in equi-librium. Whereas modifications and extensions of these “classical” currency crisis models at least took account of uncertainties about fundamentals, as has been delineated in Sect. 1.2, the aspect of uncertainty about behavior did not play a role in the earlier models. However, behavioral issues gained impor-tance in explaining the onset of financial market crises in the recent past. In the context of currency crises, it was argued that traders’ decisions typically display characteristics of strategic complementarities in the sense that similar actions reinforce each other: attacking the fixed parity is the more advanta-geous for a speculator, the larger the number of other market participants who attack as well. However, earlier models of currency crises generally stuck to the assumption of certainty, both about fundamentals and about behavior. Since each speculator’s optimal action depends on both the economic funda-mentals and on the actions taken by his opponents, these models typically give rise to multiple equilibria for an intermediate range of fundamentals, i.e. for fundamentals not so bad that it would always be optimal to attack, nor so good that it would never reward to attack. Multiple equilibria in these models are a result of self-fulfilling expectations. One set of beliefs motivates actions that bring about the outcome envisaged in those beliefs, while another set of beliefs leads to a completely different result that has again been foreseen in these expectations. Therefore, whenever speculators expect the currency peg to be sufficiently weak, they will all attack and as such force the central bank to abandon the peg. Yet, the parity could have been maintained if only the proportion of attacking speculators had been smaller.
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© 2003 Springer-Verlag Berlin Heidelberg
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Metz, C.E. (2003). Introduction. In: Information Dissemination in Currency Crises. Lecture Notes in Economics and Mathematical Systems, vol 527. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-55471-1_3
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DOI: https://doi.org/10.1007/978-3-642-55471-1_3
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