Currency Crises & Interest-Rate Defence in an Emerging Market Economy

I present a simple general equilibrium currency crisis model where the interplay between the bank deposit and lending market limits the central bank's ability to use the interest rate defence for preventing currency crises. I show that the interest rate defence will succeed in an economy where the bank lending rate volatility and interest rate margins are sufficiently high; otherwise a currency crisis coincides with a bank run and a recession. The intuition behind this result goes as follows. When the central bank raises the nominal interest rate, the consumer will reallocate his portfolio away from bank deposits, which leads to a lower lending volume and smaller profits for banks and the firm, limiting thus the central bank's willingness to raise interest rates to a level that would maintain a fixed exchange rate. In an emerging market economy where commercial bank interest rate margins are sufficiently high, banks can tolerate the central bank's interest rate defence and a fixed exchange rate can thus be maintained. The results imply that there exists a tradeoff between banking efficiency and exchange rate stability for emerging market economies.