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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 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.
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Suggested Citation

  • Flood, Robert P. & Jeanne, Olivier, 2005. "An interest rate defense of a fixed exchange rate?," Journal of International Economics, Elsevier, vol. 66(2), pages 471-484, July.
  • Handle: RePEc:eee:inecon:v:66:y:2005:i:2:p:471-484
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    JEL classification:

    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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