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Title: An Interest Rate Defence of a Fixed Exchange Rate?

Author(s): Robert P Flood and Olivier Jeanne

Publication Date: July 2000

Keyword(s): Fiscal Policy, Fixed Exchange Rate Regime and Speculative Attack

Programme Area(s): International Macroeconomics

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 defence. It is shown that increasing 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.

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Bibliographic Reference

Flood, R and Jeanne, O. 2000. 'An Interest Rate Defence of a Fixed Exchange Rate?'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=2507