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A double-edged sword. High interest rates in capital-control regimes

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  • Gylfi Zoega

Abstract

This paper derives the relationship between central bank interest rates and exchange rates under a capital control regime. Higher interest rate may strengthen the currency by reducing consumption and imports and by inducing foreign owners of local currency assets not to sell local currency off shore. There is also an effect that goes in the opposite direction: Higher interest rates increase the flow of interest income to foreigners through the current account which makes the exchange rate fall. The historical financial crisis now under way in Iceland provides excellent testing grounds for the analysis. Overall, the experience does not suggest that cutting interest rates moderately from a very high level is likely to make a currency depreciate in a capital control regime but highlights the importance of effective enforcing of the controls.

Suggested Citation

  • Gylfi Zoega, 2009. "A double-edged sword. High interest rates in capital-control regimes," Economics wp47, Department of Economics, Central bank of Iceland.
  • Handle: RePEc:ice:wpaper:wp47
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    References listed on IDEAS

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    1. Ilan Goldfajn & Poonam Gupta, 2003. "Does Monetary Policy Stabilize the Exchange Rate Following a Currency Crisis?," IMF Staff Papers, Palgrave Macmillan, vol. 50(1), pages 1-5.
    2. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "The Aftermath of Financial Crises," American Economic Review, American Economic Association, vol. 99(2), pages 466-472, May.
    3. Caporale, Guglielmo Maria & Cipollini, Andrea & Demetriades, Panicos O., 2005. "Monetary policy and the exchange rate during the Asian crisis: identification through heteroscedasticity," Journal of International Money and Finance, Elsevier, vol. 24(1), pages 39-53, February.
    4. Calvo, Guillermo A. & Izquierdo, Alejandro & Loo-Kung, Rudy, 2006. "Relative price volatility under Sudden Stops: The relevance of balance sheet effects," Journal of International Economics, Elsevier, vol. 69(1), pages 231-254, June.
    5. Christopher W. Crowe & Jonathan David Ostry & Jun I Kim & Marcos d Chamon & Atish R. Ghosh, 2009. "Coping with the Crisis; Policy Options for Emerging Market Countries," IMF Staff Position Notes 2009/08, International Monetary Fund.
    6. Akira Ariyoshi & Andrei A Kirilenko & Inci Ötker & Bernard J Laurens & Jorge I Canales Kriljenko & Karl F Habermeier, 2000. "Capital Controls; Country Experiences with Their Use and Liberalization," IMF Occasional Papers 190, International Monetary Fund.
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