The Behavior of Real Interest Rates in Exchange-Rate Based Stabilization Programs

IMF Working Papers, June 1, 1994

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Canonical URL: The Behavior of Real Interest Rates in Exchange-Rate Based Stabilization Programs

The analysis is based on a model with imperfect capital mobility and optimizing agents.
A permanent reduction in the devaluation rate is shown to have an ambiguous effect on real interest rates on impact.
For a stabilization program characterized by:
- an initial reduction in the rate of devaluation of the nominal exchange rate, and
- the announcement of a future increase in income taxes,

the impact effect on real interest rates depends upon the degree of credibility of the announcement.

Credibility scenarios:
- Real interest rates may fall if agents do not believe that taxes will be raised.
- Real interest rates may rise if the future tax reform is sufficiently credible.

The effectiveness of exchange-rate based stabilization programs in affecting real interest rates is contingent on agents’ expectations regarding future fiscal adjustments.
Announcements of future tax increases must be evaluated not only for their fiscal content but also for their credibility, since credibility can reverse the sign of the impact on real interest rates.
Policy design should account for imperfect capital mobility and optimizing behavior when anticipating interest rate responses to exchange-rate and fiscal measures.

Subjects: Bonds, Consumption, Exchange rate adjustments, Financial institutions, Financial services, Foreign exchange, Income tax systems, National accounts, Real interest rates, Taxes
Keywords: after-tax real interest rate, Bonds, Consumption, devaluation rate, exchange rate, Exchange rate adjustments, Income tax systems, nominal interest rate, opportunity cost, Real interest rates, real interest rates behavior, stabilization program, WP