Defending against speculative attacks when market opinions diverge

In a stylized continuous-time model of a small open economy with perfect capital mobility and a pegged exchange rate, I analyze an experiment in which domestic residents expect a future devaluation. Taking the public’s expectations as exogenous and allowing them to be divergent, I analyze in a short time period before the expected devaluation takes place how transactions of short-term collateralized loans among domestic residents affect the central bank’s foreign reserves and how the central bank should respond to these private transactions to reduce losses of reserves. I find when all domestic residents anticipate the devaluation, the central bank will lose the same amount of reserves from the time when the public are aware of the devaluation to the time when the devaluation is expected to take place, whether or not loan transactions among the public are permitted; but when only a fraction of the economy expect the devaluation, private loan transactions in fact escalate a run on the central bank. I use this result to interpret the interest rate defense as effort made by the central bank to eliminate private loan transactions, which otherwise would cause large reserve losses. Even though in the second case ‘killing’ all private loan transactions is better than inaction, I find in order to minimize losses of reserves, the central bank should instead encourage private borrowing and lending to exploit divergent opinions among the public. The key is to induce short-sellers to pledge domestic money as collateral when they are borrowing from others. This idea is accentuated in the first case and I show further in a set of concrete examples as the disagreement among the public widens a lower minimal loss of foreign reserves can be achieved.