Q. Explain how the timing of a balance of payment crisis is determined.  Be careful to state all assumptions.

 Answer:  The assumptions of the model are:

• Prices are elastic.
• Output is on full employment levels.
• The central bank will permit domestic credits to expand forever.
• The exchange rate is presently at E0 but will be allowed to float if foreign reserves ever fall to zero.
• Bank will preserve E0 by continuing to sell its reserves until they run out.
• Speculators in an endeavor to float the exchange rate will attempt to buy all the bank's reserves.

Now as per to the Equation 17 AII-3 (DF* = (1/m)D[PL(R,Y)] - DA). As A_, F*¯ this is true for the reason that Y is fixed and with a fixed exchange rate E R=R*.  Thus ultimately the central bank will run out of reserves and E will float. The lower panel of the graph illustrates how reserves behave over time when domestic credits A are growing.

At point T as a result of the speculative assault the rest of the reserves fall. Reserves have to decrease to zero at point T to keep asset markets in equilibrium. An attack cannot take place at T for the reason that if reserves fell to zero the exchange rate would fall to EST and everybody would then try to sell their reserves just before T for the reason that of the imminent appreciation of the home currency that will occur.

No entrepreneur would want to buy the reserves at a price of E0 for the reason that they know they are soon going to fall. The precise date on which a Balance of Payments crisis will take place and force a country to float its exchange rates has therefore been pinpointed as only being able to occur at T similarly an attack cannot take place at T because the opposite would happen.