Doctoral Dissertation Research: Costly Information Acquisition in a Speculative Attack Model: Theory and Experiments

New York University, New York NY

Investigators

Abstract

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.