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An Interest Rate Defense of a Fixed Exchange Rate?

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  • Mr. Olivier D Jeanne
  • Mr. Robert P Flood

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.

Suggested Citation

  • Mr. Olivier D Jeanne & Mr. Robert P Flood, 2000. "An Interest Rate Defense of a Fixed Exchange Rate?," IMF Working Papers 2000/159, International Monetary Fund.
    • Handle: RePEc:imf:imfwpa:2000/159
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    More about this item

    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;
    All these keywords.

    JEL classification:

    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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