Mixed Signals in Defending the Exchange Rate: What do the Data Say?

Allan Drazen and Stefan Hubrich

No 4050, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: Currency crises; Interest rate defense; Speculative attacks; Signalling (search for similar items in EconPapers)
JEL-codes: F31 F33 (search for similar items in EconPapers)
Date: 2003-09
New Economics Papers: this item is included in nep-ifn and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

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