Working Paper: NBER ID: w12616
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: Interest Rate Defense; Exchange Rate; Speculative Attack
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) | Strengthens the exchange rate (F31) |
| Raising overnight interest rates (E43) | Expected depreciation of the currency (long-term) (F31) |
| Raising overnight interest rates (E43) | Rise in risk premia associated with currency devaluation (F31) |