Interest Rate Defenses of Currency Pegs

This paper studies a policy often used to defend currency pegs: raising short-term interest rates to stem demand for foreign reserves. Yet, this mechanism is absent from most monetary models. This paper develops a model with asset market frictions where this policy can be effective. The friction I emphasize is as in Lucas (1990): the need of liquidity for asset transactions. When the government raises domestic interest rates, agents increase their domestic currency holdings in order to acquire interest-bearing domestic assets, instead of increasing their demand for the central bank's reserves, and thus the peg survives. The model shows that, while interest rate defenses can be successful, they may impose great costs for domestic agents; hence governments’ reluctance to sustain this policy for long periods. Finally, the general equilibrium nature of the model allows computing the welfare cost of this policy.