Speculative attack

In economics, a speculative attack is a precipitous acquisition of some assets (currencies, gold, emission permits, remaining quotas) by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board. Paul Krugman, who visited the Board as a graduate student intern, soon adapted their mechanism to explain speculative attacks in the foreign exchange market.

There are now many hundreds of journal articles on financial speculative attacks, which are typically grouped into three categories: first, second, and third generation models. Salant has continued to explore real speculative attacks in a series of six articles.

A speculative attack in the foreign exchange market is the massive selling of a country's currency assets by both domestic and foreign investors. Countries using a fixed exchange rate are more susceptible to a speculative attack than countries using a floating exchange rate because of the large amount of reserves necessary to hold the fixed exchange rate in place at that fixed level.

Nevertheless, if a government chooses to maintain a fixed exchange rate during a speculative attack, it risks the chance of severe economic depression or financial collapse, as illustrated by the Argentine and Asian financial crises.

Under a fixed exchange rate, the country's central bank is committed to maintaining a given price of the home currency in terms of foreign currencies by participating, when necessary, in the foreign exchange market as a buyer or seller of the country's currency to ensure that supply and demand are equated at the chosen price. When demand for the home currency becomes weaker than supply, perhaps by foreign demand for local currency to pay for the country's exports has becoming weak, maintaining equality of supply and demand for the currency at the chosen price involves the central bank stepping in as an additional demander of the local currency. The central bank does so by using its foreign exchange reserves, its holdings of foreign currency, to buy the local currency. However, it will be able to do so only until it runs out of foreign exchange reserves.

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