Interest Rate Defenses of Currency Pegs
IMF Working Papers, May 1, 2004
Source details
- Canonical URL
- Interest Rate Defenses of Currency Pegs
Other formats
Bibliographic details
- Authors: Juan Sole
- Published: May 1, 2004
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451850789.001
Research question and approach
- Studies a policy often used to defend a currency peg: raising short-term interest rates.
- Develops a general equilibrium model with asset market frictions where this policy can be effective.
- Emphasizes the friction from Lucas (1990): money is required for asset transactions.
Mechanism described
- Raising domestic interest rates increases agents' desire to hold domestic currency to acquire more domestic-currency-denominated assets.
- As a result, agents do not run on the reserves of the central bank, allowing the peg to survive.
- The paper notes this mechanism is absent from most monetary models.
Key findings and implications
- An interest rate defense can always be successful.
- Such a defense comes at great costs for domestic agents.
- The high domestic costs explain governments’ reluctance to sustain interest rate defenses for long periods of time.
Subjects and keywords
- Subjects: Asset prices, Bonds, Central bank policy rate, Currencies, Interest rate policy
- Keywords: central bank, foreign currency, interest rate, WP
Content in this bundle
- Interest Rate Defenses of Currency Pegs by Juan Sole