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A Simple Test of the Effect of Interest Rate Defense

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  • Allan Drazen
  • Stefan Hubrich

Abstract

High interest rates to defend the exchange rate signal that a government is committed to fixed exchange rates, but may also signal weak fundamentals. We test the effectiveness of the interest rate defense by disaggregating into the effects on future interest rates differentials, expectations of future exchange rates, and risk premia. While much previous empirical work has been inconclusive due to offsetting effects, tests that "disaggregate" the effects provide significant information. Raising overnight interest rates strengthens the exchange rate over the short-term, but also leads to an expected depreciation at a horizon of a year and longer and an increase in the risk premium, consistent with the argument that it also signals weak fundamentals.

Suggested Citation

  • Allan Drazen & Stefan Hubrich, 2006. "A Simple Test of the Effect of Interest Rate Defense," NBER Working Papers 12616, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:12616
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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. Drazen, Allan, 2000. "Interest-rate and borrowing defense against speculative attack," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 53(1), pages 303-348, December.
    3. Allan Drazen & Paul R. Masson, 1994. "Credibility of Policies Versus Credibility of Policymakers," The Quarterly Journal of Economics, Oxford University Press, vol. 109(3), pages 735-754.
    4. Michael P. Dooley & Jeffrey A. Frankel, 2003. "Managing Currency Crises in Emerging Markets," NBER Books, National Bureau of Economic Research, Inc, number dool03-1, January.
    5. Amartya Lahiri & Carlos A. Vegh, 2003. "Delaying the Inevitable: Interest Rate Defense and Balance of Payments Crises," Journal of Political Economy, University of Chicago Press, vol. 111(2), pages 404-424, April.
    6. Kraay, Aart, 2003. "Do high interest rates defend currencies during speculative attacks?," Journal of International Economics, Elsevier, vol. 59(2), pages 297-321, March.
    7. Jason Furman & Joseph E. Stiglitz, 1998. "Economic Crises: Evidence and Insights from East Asia," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 1-136.
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    Cited by:

    1. Sylvester C. W. Eijffinger & Benedikt Goderis, 2008. "The Effect of Monetary Policy on Exchange Rates during Currency Crises: the Role of Debt, Institutions, and Financial Openness," Review of International Economics, Wiley Blackwell, vol. 16(3), pages 559-575, August.
    2. Hnatkovska, Viktoria & Lahiri, Amartya & Vegh, Carlos A., 2013. "Interest rate and the exchange rate: A non-monotonic tale," European Economic Review, Elsevier, vol. 63(C), pages 68-93.
    3. John C. Bluedorn & Christopher Bowdler, 2010. "The Empirics of International Monetary Transmission: Identification and the Impossible Trinity," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(4), pages 679-713, June.
    4. Teimouri, Sheida & Zietz, Joachim, 2017. "Economic costs of alternative monetary policy responses to speculative currency attacks," Journal of International Money and Finance, Elsevier, vol. 73(PB), pages 419-434.
    5. Grier, Kevin & Lin, Shu, 2010. "Do high interest rates deter speculative attacks? - Evidence and some theory," Journal of International Money and Finance, Elsevier, vol. 29(5), pages 938-950, September.
    6. repec:eee:ecmode:v:67:y:2017:i:c:p:261-274 is not listed on IDEAS

    More about this item

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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