Runs on Interest Rate Pegs

Christopher Phelan and Marco Bassetto

No 255, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: Until the last couple of years, most central banks around the world conducted monetary policy by setting targets for short-term interest rates. Manoeuvering interest rates as a way to achieve low and stable inflation is now regarded as a success story. Yet this was not always the case. As mentioned by Sargent (1983), the German Reichsbank also discounted treasury and commercial bills at fixed nominal interest rates in 1923; but, rather than contributing to stabilizing the value of the mark, the policy added fuel to the hyperinflation by transferring money to the government and to the lucky holders of the discounted commercial bills. In our paper, we study the extent to which setting a short-term interest rate can be used as a way of implementing a unique equilibrium in a monetary economy. We start our analysis in a simple environment where both the central bank and Treasury trade with all agents in the economy in every period. An explicit model of the interaction among the agents in the economy allows us to clearly specify the policies of the central bank and the fiscal authority as a mapping from histories to actions. We then analyze the consequences of an interest-rate rule, where the central bank sets a price at which private agents are free to trade currency for one-period debt. When the central bank faces a limit to its ability to print money, or when private agents are limited in the amount of bonds that can be pledged to the central bank in exchange for money, an interest-rate peg leads to multiple deterministic equilibria, one with low inflation and another one with high inflation and high money growth. The second equilibrium involves a run on the central bank's interest rate target, and the shadow interest rate in the private market is different from the central bank target. We then extend the analysis to environments where agents have infrequent access to financial markets, in which an interest rate run might evolve more gradually.

Date: 2012
New Economics Papers: this item is included in nep-cba and nep-mon
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