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An Interest Rate Defense of a Fixed Exchange Rate?

  • Olivier Jeanne
  • Robert P. Flood

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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Paper provided by International Monetary Fund in its series IMF Working Papers with number 00/159.

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Length: 19
Date of creation: 01 Oct 2000
Date of revision:
Handle: RePEc:imf:imfwpa:00/159
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