A Simple Test of the Effect of Interest Rate Defense

Allan Drazen () and Stefan Hubrich

No 12616, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: F31 F33 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mon
Date: 2006-10
Note: DAE IFM
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