An Interest Rate Defense of a Fixed Exchange Rate?
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Summary:
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.
Series:
Working Paper No. 2000/159
Subject:
Conventional peg Currencies Demand for money Exchange rates Financial services Foreign exchange Interest rate parity Money
English
Publication Date:
October 1, 2000
ISBN/ISSN:
9781451857665/1018-5941
Stock No:
WPIEA1592000
Pages:
19
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