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Do High Interest Rates Defend Currencies During Speculative Attacks? New Evidence

  • Benedikt Goderis
  • Vasso P. Ioannidou

The appropriate stance of monetary policy during speculative attacks has been the source of much controversy. According to the `traditional view`, a tighter monetary policy is necessary to discourage the outflow of capital, and thus prevent the exchange rate from depreciating. The `revisionist view` argues that when speculative attacks are accompanied by substantial balance-sheet problems in the private sector, a tightening of monetary policy may actually increase the probability of devaluation. In this paper we construct a dataset that includes data on corporate short-term debt and country-specific indicators of monetary policy for countries with fixed exchange-rate regimes that faced severe speculation against their currency during the period 1986-2002. The results show that for levels of short-term debt that are not too high, an increase in interest rates decreases the probability of a currency crisis - supportive of the traditional view. This effect decreases, and eventually changes sign for higher levels of debt - supportive of the revisionist view.

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Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number WPS/2006-11.

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Date of creation: 01 Jul 2006
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Handle: RePEc:oxf:wpaper:wps/2006-11
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