Optimal portfolio choice and the collapse of a fixed-exchange rate regime

Abstract A model is presented that accounts for empirical macroeconomic regularities accompanying exchange rate crises. Assuming the Central Bank can surprise the private sector about its monetary policy, we solve for agents' consumption and portfolio decisions and the economy's equilibrium prices and interest rates using an intertemporal asset pricing model. Prior to a collapse, a ‘peso problem’ will always exist and the Central Bank will lose reserves in excess of domestic credit creation. At the time of the collapse, the exchange rate may depreciate unexpectedly. The dynamics of a country's return to fixed exchange rates are also analyzed.