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Tight Money and Central Bank Intervention (A selective analytical survey)

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  • Nissan Liviatan

    (Bank of Israel)

Abstract

This paper reviews some models of central bank intervention in the foreign exchange market in the context of tight monetary policy. It is shown that in a small open economy with capital mobility it is still possible to raise the domestic interest rate, at least temporarily, above the international one if the domestic price level exhibits some rigidity (the “overshooting hypothesis”) or if domestic and foreign bonds are imperfect substitutes. The increase in the domestic interest rate in the context of tight money often involves an increase in the risk premium as a result of the change in the asset portfolio of the public. The risk premium can be derived by using the capital asset pricing model of finance theory. Some illustrations of the change in portfolio are presented using the Israeli experience. The paper concludes with a discussion of diffusing the risk premium in a successful disinflation.

Suggested Citation

  • Nissan Liviatan, 2001. "Tight Money and Central Bank Intervention (A selective analytical survey)," Bank of Israel Working Papers 2001.03, Bank of Israel.
  • Handle: RePEc:boi:wpaper:2001.03
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    File Function: First version, 2001
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    References listed on IDEAS

    as
    1. Obstfeld, Maurice, 1983. "Exchange rates, inflation, and the sterilization problem: Germany, 1975-1981," European Economic Review, Elsevier, vol. 21(1-2), pages 161-189.
    2. Dominguez, Kathryn M & Frankel, Jeffrey A, 1993. "Does Foreign-Exchange Intervention Matter? The Portfolio Effect," American Economic Review, American Economic Association, vol. 83(5), pages 1356-1369, December.
    3. Guillermo A. Calvo, 1991. "The Perils of Sterilization," IMF Staff Papers, Palgrave Macmillan, vol. 38(4), pages 921-926, December.
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