Expectations and Contagion in Self-Fulfilling Currency Attacks

This paper shows how expectations-driven contagion of currency crises can arise even if the currency market has a unique equilibrium when viewed in isolation. The model of Morris and Shin (1998) is extended to allow speculators to trade in a second currency market. If speculators believe that a devaluation of this other currency will make a domestic devaluation more likely, they will engage in trades that link the two markets. A sharp devaluation of the other currency will then be propagated to the domestic market and will increase the likelihood of a crisis there, fulfilling the original expectations. Even though this contagion is driven solely by expectations, the model places restrictions on observable variables, and these restrictions are broadly consistent with existing empirical evidence. I thank Huberto Ennis, Paula Hernandez-Verme, Max Stinchcombe, and seminar participants at the University of Pennsylvania, Queen Mary University of London, Texas A&M University, the University of Alberta, and the 4th Annual University of Texas – ITAM Conference for useful comments.