Recently East Asian countries that have amassed large US dollar reserves
face a growing threat of big losses from a sudden decline in the dollar. This
threat evokes an issue of the optimal commitment of exchange rate
stabilization once raised by Isard (1995) who interpreted the cost of
breaking the parity as the capital gain awarded to speculators, in the event
the domestic currency is devalued. The only difference in this paper is
revaluation. This paper models the central bank’s optimal commitment to
exchange rate stabilization when it faces pressure of exchange rate
revaluation which may well describe the current episode in East Asian
countries. Using a simple equilibrium model optimizing speculators, market
maker and the central bank are explicitly introduced and the market maker’s
hedging activity is highlighted. The paper considers two equilibria, classic
market intervention and market intervention combined with direct regulation
on the market maker’s position, the latter of which believes to be commonly
exercised by some East Asian governments. The paper shows that the direct
regulation may incur larger expected loss on the central bank’s reserves
although it leaves the central bank’s interest rate policy more room to
maneuver