Staff Report, Federal Reserve Bank of New York 249
Self-fulfilling expectations are commonly believed to play an important role in the transmission of currency crises across countries. However, existing models that use multiple equilibria to illustrate the importance of such expectations have many undesirable features. This paper presents a new mechanism, based on the incomplete information framework of Morris and Shin (AER, 1998), through which self-fulfilling expectations can generate contagion. If speculators expect contagion across markets to occur, they have an incentive to trade in both currencies to take advantage of this correlation. These actions, in turn, link the two markets in such a way that a sharp devaluation of one currency will be propagated to the other market and will fulfill the original expectations. Even though the resulting model has multiple equilibria, it places restrictions on observable variables that are broadly consistent with existing empirical evidence.