Working Paper: NBER ID: w7734
Authors: Amartya Lahiri; Carlos A. Vgh
Abstract: The classical model of balance of payments crises implicitly assumes that the central bank sits passively as international reserves dwindle. In practice, however, central banks typically defend pegs aggressively by raising short-term interest rates. This paper analyzes the feasibility and optimality of raising interest rates to delay a potential BOP crisis. Interest rate policy works through two distinct channels. By raising demand for domestic, interest-bearing liquid assets, higher interest rates tend to delay the crisis. Higher interest rates, however, increase public debt service and imply higher future inflation, which tends to bring forward the crisis. We show that, under certain conditions, it is feasible to delay the crisis, but raising interest rates beyond a certain point may actually hasten the crisis. A similar non-monotonic relationship emerges between welfare and the increase in interest rates. It is thus optimal to engage in some active interest rate defense but only up to a certain point. In fact, there is a whole range of interest rate increases for which it is feasible to delay the crisis but not optimal to do so.
Keywords: No keywords provided
JEL Codes: F41; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher interest rates (E43) | Delayed balance of payments crisis (F32) |
| Higher interest rates (E43) | Hasten balance of payments crisis (F32) |
| Public debt service and future inflation (H63) | Timing of balance of payments crisis (F32) |