An Interest Rate Defense of a Fixed Exchange Rate?

Olivier Jeanne and Robert Flood

No 2000/159, IMF Working Papers from International Monetary Fund

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 defense. It is shown that increasing the 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: WP; interest rate; money supply; nominal interest rate; Speculative attack; fixed exchange rate regime; fiscal policy; interest rate defense; ill-conceived interest rate strategy; collapse interest rate; interest rate rise; currency peg; defense in the Krugman-Flood-Garber; currency-peg collapse; Exchange rates; Conventional peg; Currencies; Demand for money; Interest rate parity; Southeast Asia; East Asia; Global (search for similar items in EconPapers)
Pages: 19
Date: 2000-10-01
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Citations: View citations in EconPapers (44)

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