The last decade of the twentieth century and the beginning of this century were characterized by frequent episodes of currency crises. These environments of high speculation are characterized by investor?s uncertainty about the state of the economy and about the actions that other investors will take. Traditional models of currency crises assumed that all investors held the same information, which led to poor policy recommendations because they could not predict outcomes. The main predictions were that in bad states of the economy investors attack the currency and provoke a devaluation for sure, in good states investors restrain from attacking and devaluation never takes place, and in intermediate states there are multiple outcomes where investors attack if they believe that others will attack, and restrain from attacking if they believe that others will not attack. While these models seemed to explain the occurrence of currency crises, they could only offer a limited amount of policy guidance due to the self fulfilling nature of the outcomes.
Recent research has focused on the role that private information plays in determining outcomes through the study of coordination games where investors only hold private and incomplete information about the state of the economy. By restraining agents to hold only noisy private information (as opposed to public or common information), this methodology pins down unique predictions that remove the self fulfilling nature of the previous models. This has allowed economists to have a better understanding of the forces behind episodes of high speculation and to make more accurate policy recommendations. Nevertheless, it is the information that each investor holds that determines his decision to attack a currency or to make an investment. In these models, however, the noisy private information possessed by agents is given to them exogenously, rather than chosen. The research outlined in this project rectifies this shortcoming by theoretically and experimentally studying costly information acquisition in a speculative attack where agents only hold private information. This is done by allowing agents to improve the accuracy of their private information about the state of the economy, at a cost. Once agents have chosen the precision of their information, they take part in the speculative attack game. The present research project predicts unique outcomes that depend on the precision choices of agents, which allows for accurate policy recommendations. The study of costly information acquisition in a speculative attack will bring the model closer to reality. Investors involved in speculative attacks continuously make efforts to improve the information they possess, and they are willing to pay for it. Investment groups and individuals pay experts to extract more accurate information about the financial system in order to minimize losses, creating a market for information expertise and financial advising (examples of financial advising corporations include Merril Lynch, Morgan Stanley, Goldman Sachs, etc.). The existence of such a market for information suggests that the inclusion of costly information acquisition in a model of speculative attacks is necessary to better understand the mechanism behind currency crises, which have proven to be very detrimental to the economy.
The theoretical predictions suggest that the decision to attack depends on the quality of information chosen by each of the agents. To fully understand the policy implications that derive from the theory it is necessary to understand how agents actually behave when facing this situation, which is why this project proposes to test the predictions of the theory experimentally. The following questions are asked: In a world in which investors have the possibility to pay a cost to improve the quality of the information they possess about the economy, is it possible to reduce the incidence of speculative attacks? Can currency crises be prevented by having better informed market participants? What role do financial advisors play in determining speculative attack outcomes? The proposed study intends to shed light on these and other policy issues, which will contribute to a better understanding of the forces behind periods of economic crisis. The analysis outlined in this project can also be applied to other economic phenomena that have been studied with similar modeling techniques, such as bank runs, debt crises, or Foreign Direct Investment decisions. Hence, this research project contributes to the understanding of the role of costly information acquisition in a wide range of coordination games with noisy private information that arise in macroeconomics.
In this project we have studied theoretically and experimentally the role of information acquisition in the context of speculative attacks, such as the ones characterizing currency crises. In the previous models the private information possessed by agents was given to them exogenously, rather than chosen. In this project we have contributed to the literature by studying costly information acquisition in a speculative attack where agents can improve the accuracy of their private information about the state of the economy, at a cost. Once agents have chosen the precision of their information, they take part in the speculative attack game of currency crisis. This research has contributed to the understanding of speculative behavior by bringing the model closer to reality, as is the objective of this type of stylized economic models. Investors involved in speculative attacks continuously make efforts to improve the information they possess, and they are willing to pay for it. Investment groups and individuals pay experts to extract more accurate information about the financial system in order to minimize losses, creating a market for information expertise and financial advising (examples of financial advising corporations include Merril Lynch, Morgan Stanley, Goldman Sachs, etc.). The existence of such a market for information suggests that the inclusion of costly information acquisition in a model of speculative attacks is necessary to better understand the mechanism behind currency crises, which have proven to be very detrimental to the economy. The theoretical predictions state how the decision to attack depends on the quality of information chosen by each of the agents. However, to fully understand the policy implications that derive from the theory we have run an experiment to understand how people actually behave when facing this situation. What we observe in the experiment is that many of the theoretical predictions hold in the laboratory, meaning that the model that we have developed captures qualitatively the type of behavior that people exhibit in this type of situations. However, opposite to what the theory suggests, we observe a significant departure in the way that subjects in the experiment use the information they purchase on their decision to attack. While the theory predicts that having better informed market participants would lead to a lower incidence of attacks, we observe that as subjects in the experiment choose more precise information, they actually attack more. As a result, the overall success of attacks increases for better informed market participants: they achieve higher individual payoffs by coordinating on successful attacks for a wider range of fundamentals. This leads us to believe that subjects who coordinate on high levels of precision might actually be forming an implicit agreement by which they decide to bear a high cost in order to get a very accurate information that would minimize the probability of attacking in bad states. It is shown that this cooperative agreement actually leads to higher average payoffs than the expected payoffs that would have arisen if subjects had behaved in accordance with the theory. Our experimental results show that having better quality of information leads to a significant increase in individual investor's welfare since it allows them to extract higher payoffs than equilibrium play. This feature of our experimental analysis has important policy implications in the context of a speculative attack. In this particular context, even if this behavior improves the welfare of individuals, an increased incidence and success of speculative attacks is detrimental for society, as proven by the numerous episodes of currency crises in the last two decades. In this sense, the results of the experiment illustrate the trade off between individual and social welfare in episodes of speculative attack when agents can improve their private information at a cost. This finding sheds light on the importance for policy making of taking into account the role that private information acquisition plays on speculative attack outcomes. Nevertheless, our results can also be applied to different contexts (e.g. an investment decision or a social revolt), in which case different qualitative implications on welfare might apply.
