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Interest-rate Defenses of Currency Pegs

Author

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  • Juan Sole

Abstract

This paper studies a policy often used to defend a currency peg: raising short-term interest rates. The rationale for this policy is to stem demand for foreign reserves. Yet, this mechanism is absent from most monetary models. This paper develops a general equilibrium model with asset market frictions where this policy can be effective. The friction I emphasize is the same as in Lucas (1990): money is required for asset transactions. When the government raises domestic interest rates, agents want to increase their holdings of domestic currency in order to acquire more domestic-currency-denominated assets. Thus, agents do not run on the reserves of the central bank, and the peg survives. A key implication of the model is that an interest rate defense can always be successful, but at great costs for domestic agents. Hence the reluctance of governments to sustain this policy for long periods of time.

Suggested Citation

  • Juan Sole, 2004. "Interest-rate Defenses of Currency Pegs," 2004 Meeting Papers 306, Society for Economic Dynamics.
    • Handle: RePEc:red:sed004:306
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    Cited by:

    1. Kyung-Soo Kim, 2006. "An Optimal Commitment Model of Exchange Rate Stabilization," Korean Economic Review, Korean Economic Association, vol. 22, pages 249-265.

    More about this item

    Keywords

    Interest rates; exchange rates; currency crises;
    All these keywords.

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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