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Output Costs, Currency Crises and Interest Rate Defence of a Peg

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  • Amartya Lahiri
  • Carlos A. Végh

Abstract

Central banks typically raise short-term interest rates to defend currency pegs. Higher interest rates, however, often lead to a credit crunch and an output contraction. We model this trade-off in an optimising, first-generation model in which the crisis may be delayed but is ultimately inevitable. We show that higher interest rates may delay the crisis, but raising interest rates beyond a certain point may actually bring forward the crisis due to the large negative output effect. The optimal interest rate defence involves setting high interest rates (relative to the no defence case) both before and at the moment of the crisis. Copyright 2007 The Author(s). Journal compilation Royal Economic Society 2007.

Suggested Citation

  • Amartya Lahiri & Carlos A. Végh, 2007. "Output Costs, Currency Crises and Interest Rate Defence of a Peg," Economic Journal, Royal Economic Society, vol. 117(516), pages 216-239, January.
  • Handle: RePEc:ecj:econjl:v:117:y:2007:i:516:p:216-239
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    Cited by:

    1. Axel Dreher & Bernhard Herz & Volker Karb, 2006. "Is there a causal link between currency and debt crises?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 11(4), pages 305-325.
    2. Teimouri, Sheida & Zietz, Joachim, 2017. "Economic costs of alternative monetary policy responses to speculative currency attacks," Journal of International Money and Finance, Elsevier, vol. 73(PB), pages 419-434.
    3. Sylvester C. W. Eijffinger & Benedikt Goderis, 2008. "The Effect of Monetary Policy on Exchange Rates during Currency Crises: the Role of Debt, Institutions, and Financial Openness," Review of International Economics, Wiley Blackwell, vol. 16(3), pages 559-575, August.
    4. Dąbrowski, Marek A. & Śmiech, Sławomir & Papież, Monika, 2015. "Monetary policy options for mitigating the impact of the global financial crisis on emerging market economies," Journal of International Money and Finance, Elsevier, vol. 51(C), pages 409-431.
    5. Hutchison, Michael M. & Noy, Ilan & Wang, Lidan, 2010. "Fiscal and monetary policies and the cost of sudden stops," Journal of International Money and Finance, Elsevier, vol. 29(6), pages 973-987, October.
    6. Daniëls, Tijmen R. & Jager, Henk & Klaassen, Franc, 2011. "Currency crises with the threat of an interest rate defence," Journal of International Economics, Elsevier, vol. 85(1), pages 14-24, September.
    7. Tsangarides, Charalambos G., 2012. "Crisis and recovery: Role of the exchange rate regime in emerging market economies," Journal of Macroeconomics, Elsevier, vol. 34(2), pages 470-488.
    8. Erler, Alexander & Bauer, Christian & Herz, Bernhard, 2015. "To intervene, or not to intervene: Monetary policy and the costs of currency crises," Journal of International Money and Finance, Elsevier, vol. 51(C), pages 432-456.
    9. repec:mes:emfitr:v:53:y:2017:i:11:p:2545-2561 is not listed on IDEAS
    10. Ryota Nakatani, 2016. "Twin Banking and Currency Crises and Monetary Policy," Open Economies Review, Springer, vol. 27(4), pages 747-767, September.
    11. Tijmen R. Daniels & Henk Jager & Franc Klaassen, 2008. "Defending against Speculative Attacks," Tinbergen Institute Discussion Papers 08-090/2, Tinbergen Institute, revised 06 Apr 2009.
    12. Erler, Alexander & Bauer, Christian & Herz, Bernhard, 2014. "Defending against speculative attacks – It is risky, but it can pay off," Journal of Banking & Finance, Elsevier, vol. 47(C), pages 309-330.
    13. Nadav Ben Zeev, 2017. "Exchange Rate Regimes And Sudden Stops," Working Papers 1712, Ben-Gurion University of the Negev, Department of Economics.
    14. Singh, Rajesh, 2009. "Asset prices and twin crises," Journal of International Money and Finance, Elsevier, vol. 28(1), pages 26-55, February.
    15. repec:eee:reecon:v:71:y:2017:i:3:p:373-383 is not listed on IDEAS

    More about this item

    JEL classification:

    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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