An Interest Rate Defense of a Fixed Exchange Rate?

By Robert P. Flood, Olivier Jeanne. Social Science Research Network, 2000

118 citations recorded by the source corpus.

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.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/c1f323de6b941a9f94bba6afc7fec243259c9e3d