Working Paper: CEPR ID: DP4050
Authors: Allan Drazen; Stefan Hubrich
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.
Keywords: currency crises; interest rate defense; signaling; speculative attacks
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Raising overnight interest rates (E43) | Strengthening of exchange rate in the short term (F31) |
| Raising overnight interest rates (E43) | Expected depreciation of exchange rate after one year (F31) |
| Raising overnight interest rates (E43) | Increase in risk premiums (G19) |
| Raising overnight interest rates (E43) | Reassessment of likelihood of currency collapse by speculators (F31) |
| High interest rates (E43) | Deter speculation in the short run (D84) |
| High interest rates (E43) | Exacerbate risks in the long run due to signaling of weak economic fundamentals (F65) |