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An Interest Rate Defence 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 defence. It is shown that increasing 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.

Suggested Citation

  • Flood, Robert P & Jeanne, Olivier, 2000. "An Interest Rate Defence of a Fixed Exchange Rate?," CEPR Discussion Papers 2507, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:2507
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    References listed on IDEAS

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    More about this item

    Keywords

    Fiscal Policy; Fixed Exchange Rate Regime; Speculative Attack;

    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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