MIT and NBER

This paper examines the ability of a policy maker to control equilibrium outcomes in an envi-ronment where market participants play a coordination game with information heterogeneity. We consider defense policies against speculative currency attacks. In contrast to Morris and Shin (1998), we find that policy endogeneity leads to multiple equilibria even when the “funda-mentals ” are observed with noise. The policy maker is willing to take a costly policy action only for moderate fundamentals. Market participants can use this information to coordinate on dif-ferent responses to the same policy action, thus resulting in policy traps, where the devaluation outcome and the shape of the optimal policy are dictated by self fulfilling market expectations. Despite equilibrium indeterminacy, robust policy predictions can be made. The probability of devaluation is monotonic, the policy maker is “anxious to prove herself ” by raising the interest rate only for a small region of moderate fundamentals, and the “anxiety region ” vanishes as the information in the market becomes precise