When the Penny Doesn’t Drop – Macroeconomic Tail Risk and Currency Crises

We extend the canonical global game model of currency crises to allow for macroeconomic tail risk. The exchange rate peg is attacked if fundamentals reach a critical threshold, or if there is a sufficiently large public shock. Large shocks generate doubt amongst investors about both the state of the world and about what others know, giving rise to multiple equilibria. We find a non-monotonic relationship between tail risk and the probability of (a fundamentals-based) crisis and show how this effect depends on the magnitude and direction of public shocks. Our analysis sheds new light on the way in which international financial contagion played a part in the sterling crisis of 1931.