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Interest Rate Defenses of Currency Pegs

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  • Juan Sole

Abstract

This paper studies a policy often used to defend a currency peg: raising short-term interest rates. The rationale for this policy is to stem demand for foreign reserves. Yet, this mechanism is absent from most monetary models. This paper develops a general equilibrium model with asset market frictions where this policy can be effective. The friction I emphasize is the same as in Lucas (1990): money is required for asset transactions. When the government raises domestic interest rates, agents want to increase their holdings of domestic currency in order to acquire more domestic-currency-denominated assets. Thus, agents do not run on the reserves of the central bank, and the peg survives. A key implication of the model is that an interest rate defense can always be successful, but at great costs for domestic agents. Hence the reluctance of governments to sustain this policy for long periods of time.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 04/85.

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Length: 35
Date of creation: 01 May 2004
Date of revision:
Handle: RePEc:imf:imfwpa:04/85

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Keywords: Interest rates; Exchange rates; Currency pegs; Exchange rate regimes; bond; central bank; bonds; domestic currency; interest rate policy; currency crises; bond prices; bond price; domestic agents; currency crisis; domestic bonds; domestic bond; foreign bond; foreign bonds; bond sales; government bonds; demand for bonds; domestic interest rates; bondholders; international capital; financial assets; state bond; discount bond; central banks; government bond; domestic agent; reserve bank; international capital mobility; domestic-currency; balance of payments; crisis countries; discount bonds; reserve banks; financial market; domestic growth; foreign bond market; discount price; bond market; money markets;

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  1. Kumhof, Michael, 2001. "International Capital Mobility in Emerging Markets: New Evidence from Daily Data," Review of International Economics, Wiley Blackwell, Wiley Blackwell, vol. 9(4), pages 626-40, November.
  2. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, Elsevier, vol. 50(2), pages 237-264, April.
  3. Kraay, Aart, 2003. "Do high interest rates defend currencies during speculative attacks?," Journal of International Economics, Elsevier, Elsevier, vol. 59(2), pages 297-321, March.
  4. Andrew K. Rose & Robert P. Flood, 2001. "Uncovered Interest Parity in Crisis," IMF Working Papers 01/207, International Monetary Fund.
  5. Grilli, Vittorio & Roubini, Nouriel, 1992. "Liquidity and exchange rates," Journal of International Economics, Elsevier, Elsevier, vol. 32(3-4), pages 339-352, May.
  6. 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.
  7. Allan Drazen, 2003. "Interest Rate Defense against Speculative Attack as a Signal. A Primer," NBER Chapters, National Bureau of Economic Research, Inc, in: Managing Currency Crises in Emerging Markets, pages 37-60 National Bureau of Economic Research, Inc.
  8. Helpman, Elhanan & Razin, Assaf, 1985. "Floating exchange rates with liquidity constraints in financial markets," Journal of International Economics, Elsevier, Elsevier, vol. 19(1-2), pages 99-117, August.
  9. Menzie D. Chinn & Michael P. Dooley, 1997. "Asia Pacific Capital Markets: Integration and Implications for Economic Activity," NBER Chapters, National Bureau of Economic Research, Inc, in: Regionalism versus Multilateral Trade Arrangements, NBER-EASE Volume 6, pages 169-202 National Bureau of Economic Research, Inc.
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