Discussion Paper Details

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Title: Mixed Signals in Defending the Exchange Rate: What do the Data Say?

Author(s): Allan Drazen and Stefan Hubrich

Publication Date: September 2003

Keyword(s): currency crises, interest rate defense, signalling and speculative attacks

Programme Area(s): International Macroeconomics

Abstract: High interest rates to defend the exchange rate signal that a government is committed to fixed exchange rates, but may also signal weak fundamentals. We test the effectiveness of the interest rate defense by disaggregating into the effects on future interest rates differentials, expectations of future exchange rates, and risk premia. While much previous empirical work has been inconclusive due to offsetting effects, tests that ?disaggregate? the effects provide significant information. Raising overnight interest rates strengthens the exchange rate over the short-term, but also leads to an expected depreciation at a horizon of a year and longer and an increase in the risk premium, consistent with the argument that it also signals weak fundamentals.

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Bibliographic Reference

Drazen, A and Hubrich, S. 2003. 'Mixed Signals in Defending the Exchange Rate: What do the Data Say?'. London, Centre for Economic Policy Research.