DP2507 An Interest Rate Defence of a Fixed Exchange Rate?

Author(s): Robert P Flood, Olivier Jeanne
Publication Date: July 2000
Keyword(s): Fiscal Policy, Fixed Exchange Rate Regime, Speculative Attack
JEL(s): F32, F33
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2507

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.