An Interest Rate Defense of a Fixed Exchange Rate?

Author/Editor:

Olivier D Jeanne ; Robert P Flood

Publication Date:

October 1, 2000

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

Defending a government’s exchange-rate commitment with active interest rate policy is not an option in the Krugman-Flood-Garber (KFG) model of speculative attacks. In that model, the interest rate is the passive reflection of currency-depreciation expectations. In this paper we show how to adapt the KFG model to allow for an interest rate defense. It is shown that increasing the domestic-currency interest rate makes domestic assets more attractive according to an asset substitution effect, but weakens the domestic currency by increasing the government’s fiscal liabilities. As a result, raising the interest rate hastens the speculative attack when speculation is motivated by underlying fiscal fragility.

Series:

Working Paper No. 2000/159

Subject:

Conventional peg Currencies Demand for money Exchange rates Financial services Foreign exchange Interest rate parity Money

English

Publication Date:

October 1, 2000

ISBN/ISSN:

9781451857665/1018-5941

Stock No:

WPIEA1592000

Pages:

19

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