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An interest rate defense of a fixed exchange rate?

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  • Flood, Robert P.
  • Jeanne, Olivier

Abstract

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 defence. It is shown that increasing 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.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 66 (2005)
Issue (Month): 2 (July)
Pages: 471-484

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Handle: RePEc:eee:inecon:v:66:y:2005:i:2:p:471-484

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Web page: http://www.elsevier.com/locate/inca/505552

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  1. Woodford, Michael, 1995. "Price-level determinacy without control of a monetary aggregate," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 43(1), pages 1-46, December.
  2. Burnside, C. & Eichenbaum, M. & Rebelo, S., 1998. "Prospective Deficits and the Asian Currency Crisis," RCER Working Papers 458, University of Rochester - Center for Economic Research (RCER).
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  4. Amartya Lahiri & Carlos A. Vegh, 2000. "Delaying the Inevitable: Optimal Interest Rate Policy and BOP Crises," NBER Working Papers 7734, National Bureau of Economic Research, Inc.
  5. Nancy P. Marion & Robert P. Flood, 1998. "Perspectiveson the Recent Currency Crisis Literature," IMF Working Papers 98/130, International Monetary Fund.
  6. van Wijnbergen, Sweder, 1985. "Fiscal Deficits, Exchange Rate Crises and Inflation," CEPR Discussion Papers, C.E.P.R. Discussion Papers 87, C.E.P.R. Discussion Papers.
  7. Willem H. Buiter, 1986. "Borrowing to Defend the Exchange Rate and the Timing and Magnitude of Speculative Attacks," NBER Working Papers 1844, National Bureau of Economic Research, Inc.
  8. Flood, Robert P. & Marion, Nancy P., 2000. "Self-fulfilling risk predictions:: an application to speculative attacks," Journal of International Economics, Elsevier, Elsevier, vol. 50(1), pages 245-268, February.
  9. Daniel, Betty C, 2001. "A Fiscal Theory of Currency Crises," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(4), pages 969-88, November.
  10. Obstfeld, Maurice, 1986. "Rational and Self-fulfilling Balance-of-Payments Crises," American Economic Review, American Economic Association, American Economic Association, vol. 76(1), pages 72-81, March.
  11. Jason Furman & Joseph E. Stiglitz, 1998. "Economic Crises: Evidence and Insights from East Asia," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 1-136.
  12. Timothy D. Lane & Marianne Schulze-Gattas & T. M. Tsikata & Steven Phillips & Atish R. Ghosh & A. Javier Hamann, 1999. "IMF-Supported Programs in Indonesia, Korea and Thailand," IMF Occasional Papers 178, International Monetary Fund.
  13. Kraay, Aart, 2000. "Do high interest rates defend currencies during speculative attacks ?," Policy Research Working Paper Series 2267, The World Bank.
  14. Drazen, Allan & Helpman, Elhanan, 1987. "Stabilization with Exchange Rate Management," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 102(4), pages 835-55, November.
  15. Bensaid, B.B. & Jeanne, O., 1995. "The Instability of Fixed Exchange Rate Systems when Raising the Nominal Interest Rate is Costly," Papers, Tilburg - Center for Economic Research 9536, Tilburg - Center for Economic Research.
  16. Amartya Lahiri & Carlos A. Vegh, 2003. "Delaying the Inevitable: Interest Rate Defense and Balance of Payments Crises," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 111(2), pages 404-424, April.
  17. Olivier Jeanne & Andrew K. Rose, 1999. "Noise Trading and Exchange Rate Regimes," NBER Working Papers 7104, National Bureau of Economic Research, Inc.
  18. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 11(3), pages 311-25, August.
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  20. Cuthbertson, Keith & Galindo, Luis, 1999. "The Demand for Money in Mexico," Manchester School, University of Manchester, vol. 67(2), pages 154-66, March.
  21. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, Elsevier, vol. 17(1-2), pages 1-13, August.
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  24. Andrew Berg, 1999. "The Asia Crisis," IMF Working Papers 99/138, International Monetary Fund.
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