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Monetary Policy, Default Risk and the Exchange Rate

  • Guimarães, Bernardo
  • Soares Gonçalves, Carlos Eduardo

In a country with high probability of default, higher interest rates may render the currency less attractive if sovereign default is costly. This paper develops that intuition in a simple model and estimates the effect of changes in interest rates on the exchange rate in Brazil using data from the dates surrounding the monetary policy committee meetings and the methodology of identification through heteroskedasticity. Indeed, we find that unexpected increases in interest rates tend to lead the Brazilian currency to depreciate. It follows that granting more independence to a central bank that focus solely on inflation is not always a free-lunch.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6501.

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Date of creation: Sep 2007
Date of revision:
Handle: RePEc:cpr:ceprdp:6501
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  1. Andrew K. Rose, 2002. "One Reason Countries Pay their Debts: Renegotiation and International Trade," EUI-RSCAS Working Papers 18, European University Institute (EUI), Robert Schuman Centre of Advanced Studies (RSCAS).
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  3. Frederic S. Mishkin, 2004. "Can Inflation Targeting Work in Emerging Market Countries?," NBER Working Papers 10646, National Bureau of Economic Research, Inc.
  4. Jeromin Zettelmeyer, 2000. "The Impact of Monetary Policyon the Exchange Rate: Evidence From Three Small Open Economies," IMF Working Papers 00/141, International Monetary Fund.
  5. Rigobon, Roberto & Sack, Brian, 2004. "The impact of monetary policy on asset prices," Journal of Monetary Economics, Elsevier, vol. 51(8), pages 1553-1575, November.
  6. Akemann, Michael & Kanczuk, Fabio, 2005. "Sovereign default and the sustainability risk premium effect," Journal of Development Economics, Elsevier, vol. 76(1), pages 53-69, February.
  7. Drazen, Allan & Masson, Paul R, 1994. "Credibility of Policies versus Credibility of Policymakers," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 735-54, August.
  8. Roberto Rigobon, 2003. "Identification Through Heteroskedasticity," The Review of Economics and Statistics, MIT Press, vol. 85(4), pages 777-792, November.
  9. Daniel Cohen & Jeffrey Sachs, 1985. "Growth and External Debt Under Risk of Debt Repudiation," NBER Working Papers 1703, National Bureau of Economic Research, Inc.
  10. Guglielmo Maria Caporale & Andrea Cipollini & Panicos Demetriades, 2000. "Monetary Policy and the Exchange Rate During the Asian Crisis Identification Through Heteroscedasticity," Discussion Papers in Economics 00/11, Department of Economics, University of Leicester, revised Feb 2002.
  11. David Backus & John Driffill, 1984. "Inflation and Reputation," Working Papers 560, Queen's University, Department of Economics.
  12. Dongchul Cho & Kenneth D. West, 2003. "Interest Rates and Exchange Rates in the Korean, Philippine, and Thai Exchange Rate Crises," NBER Chapters, in: Managing Currency Crises in Emerging Markets, pages 11-36 National Bureau of Economic Research, Inc.
  13. Michael P. Dooley & Jeffrey A. Frankel, 2003. "Managing Currency Crises in Emerging Markets," NBER Books, National Bureau of Economic Research, Inc, number dool03-1, December.
  14. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
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