Working Paper: CEPR ID: DP2507
Authors: Robert P. Flood; Olivier Jeanne
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.
Keywords: Fiscal Policy; Fixed Exchange Rate Regime; Speculative Attack
JEL Codes: F32; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increase in domestic currency interest rates (E43) | worsens government's fiscal situation (H69) |
| worsens government's fiscal situation (H69) | increases probability of currency collapse (F31) |
| increase in domestic currency interest rates (E43) | currency instability (F31) |
| higher interest rates post-collapse (F65) | increased seigniorage revenues (H69) |
| increased seigniorage revenues (H69) | help service debt (H63) |
| initial increase in rates (E43) | exacerbates fiscal problems (E62) |
| exacerbates fiscal problems (E62) | leads to further currency depreciation (F31) |