An Interest Rate Defence of a Fixed Exchange Rate?

Robert Flood () and Olivier Jeanne

No 2507, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: 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 defence. It is shown that increasing 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.

Keywords: Speculative attack; Fixed exchange rate regime; Fiscal policy (search for similar items in EconPapers)
JEL-codes: F32 F33 (search for similar items in EconPapers)
Date: 2000-07
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Citations: View citations in EconPapers (2)

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Journal Article: An interest rate defense of a fixed exchange rate? (2005)
Working Paper: An Interest Rate Defense of a Fixed Exchange Rate? (2000)
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