Question

Describe how, in a fixed exchange rate regime, expectations of a currency devaluation can ultimately be self fulfilling.

Answer 1

Self fulfilling crisis are the crisis that occur due to the pessimistic expectations of investors.

Under a fixed exchange rate, a currency crisis can occur when a country runs persistent balance of payment deficits while attempting to maintain its fixed exchange rate. This can force a country to devalue its currency.

However, anticipation of a BOP crisis will indue investors to sell its domestic assets in favor of foreign assets ( capital flight). This will worsen the balance of payments problem and thus can induce a crisis to occur.