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Interest Rate Defenses of Currency Pegs

Author/Editor: Sole, Juan
Authorized for Distribution: May 1, 2004
Electronic Access: Free Full Text (PDF file size is 5,038KB)
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Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Summary: 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.
 
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Series: Working Paper No. 04/85
Subject(s): Interest rates | Currency pegs | Exchange rate regimes
Author's keyword(s): Interest rates | exchange rates | currency crises
 
English  
    Published:   May 1, 2004        
    ISBN/ISSN:   1934-7073   Format:   Paper
    Stock No:   WPIEA0852004   Pages:   35
    Price:   US$15.00 (Academic Rate: US$15.00 )
       
     
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